Fiscal Deficit and Sovereign Debt g Crisis

The Problem
Suppose that, starting from a balanced budget, the government cuts taxes, creating a budget deficit. deficit What will happen to debt over time? Will the government need to increase taxes later? If so, by how much? , y

The Arithmetic of Deficits and Debt

The budget deficit in year t equals:
deficit t rBt 1 Gt Tt
Bt-1 i th government d bt at th end of year t-1 or, equivalently at is the t debt t the d f i l tl t the beginning of year t.; r is the real interest rate, assumed to be constant here. Thus,

rBt 1

is the real interest payments on government debt in year t.

Gt iis government spending d i year t. t di during Tt

is taxes minus transfers during year t. In words: The budget deficit equals spending, including interest p y g payments on the debt, minus , taxes net of transfers.

The Arithmetic of Deficits and Debt

Do not confuse the words deficit and debt. Debt is a stock, what the government owes as a result of past deficits. The deficit is a flow how deficits flow, much the government borrows during a given year.

Thus the change in government debt during year t is equal to the deficit during year t:

Bt Bt1 deficitt
It is often convenient to decompose the deficit into the sum of two terms: Interest payments on the debt rBtt-1 debt, 1 The difference between spending and taxes, Gt- Tt. This term p y ( q y, is called the primary deficit (equivalently, Tt Gt is called the primary surplus).

TheArithmeticofDeficitsandDebt
Bt Bt 1
change i th d bt h in the debt

rBt 1
interest payments i t t t

Gt Tt
Primary deficit Pi d fi it

Bt (1 r ) Bt 1 Gt Tt
Debt at the end of year t equals (1 + r) times debt at the end of year t 1 plus primary deficit at the end of year t Gt- Tt. 1, t,

Current Versus Future Taxes

Lets look at the implications of a 1-year decrease in taxes for the path of debt and future taxes We start from a situation where, until Year 1, the government has balanced its budget, so the initial debt is zero. During Year 1, the government decreases taxes by 1 (think one crore rupees, for example) for 1 year. Thus debt at the end of Year 1, B1, is equal to 1. What happens thereafter?

Full Repayment in Year 2

B2 (1 r ) B1 (G2 T2 )
If debt is fully repaid in Year 2, then debt at the end of Year 2 is equal to zero. Replacing B2=0 and B1=1 and rearranging: zero =1,

T2 G2 (1 r )1 (1 r )
In words, to repay the debt fully in year 2, the government must run a primary surplus equal to (1+r). It can do so in two ways: a (1 r). decrease in spending or an increase in taxes. We assume that adjustment comes through taxes so that the taxes, path of spending is unaffected. It follows that the decrease in y g y taxes by 1 during Year 1 must be offset by an increase in taxes by (1+r) during Year 2.

Full Repayment in Year 2

(a) If debt is fully repaid during y 2, p g year , the decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+r) in Year 2. (1+r

T2 G2 (1 r )1 (1 r )

Full Repayment in Year 5

If debt is fully repaid during year 5 the 5, decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+r)4 during year 5. (1+r Despite the fact that taxes are cut only in Year 1, debt keeps increasing over time, at a rate equal to the interest rate. The reason is simple: While the primary deficit is equal to zero, zero debt is now positive, and so are interest payments on the debt Each year the positive debt. year, government must issue more debt to pay the interest on existing debt.

Full Repayment in Year t

Our first set of conclusions:

If government spending is unchanged, a decrease in taxes must eventually be offset by an increase in taxes in the future. The longer the government waits to increase taxes, or the higher the real interest rate, the g higher the eventual increase in taxes.

Debt Stabilization in Year t

We h W have assumed so f that the government f ll repays the debt. Lets now llook at d far h h fully h d b L k what happens to taxes if the government only stabilizes the debt. Stabilizing the debt means changing taxes or spending so that debt remains constant from then on. Suppose that the government decides to stabilize the debt from Year 2 on.

DebtStabilizationinYeart
From Bt (1 r ) Bt 1 constraint for year 2 is

Gt Tt , the budget

B2 (1 r ) B1 (G2 T2 )
Under U d our assumption th t d bt is stabilized i ti that debt i t bili d in Year 2, B2 B1 1 . Replacing in the preceding equation:

1 (1 r ) (G2 T2 )

Reorganizing and bringing (G2 T2 ) to the left side:

T2 G2 (1 r ) 1 r

Debt Stabilization in Year t

If debt is stabilized d b i bili d from Year 2 on, then taxes must be permanently higher by r from Year 2 on.

Debt Stabilization in Year t

From the preceding arithmetic of deficits and debt we can draw these conclusions:

Th legacy of past deficits i hi h f The l f t d fi it is higher for government debt. To stabilize the debt, the government must eliminate the deficit. To eliminate the deficit, the government must run a primary surplus equal to the interest p y p q payments on the existing debt. This requires higher taxes forever. g

The Evolution of the Debt to GDP Ratio Debt-to-GDP

In an economy in which output grows over time, it makes sense to focus on the ratio of debt to output. The d bt t GDP ratio, or d bt ratio gives th evolution Th debt-to-GDP ti debt ti i the l ti of the ratio of debt to GDP.

Advanced Economies: Gross Debt-to-GDP Ratios, 2010 IMF Projections

Debt-GDP ratios have been pushed up dramatically in many countries
250 225 200 175 150 125 Percent (%) of GDP

Japan Greece g Belgium France Portugal

Iceland Italy USA Canada Israel Germany Austria Spain

100 75 50 25 0

UK Ireland Netherl

Strategies for Fiscal Consolidation in the Post-Crisis World, IMF, February 4, 2010

Indebtedness of the worlds governments

Country Japan Italy Greece Belgium g U.S.A. France Portugal Germany Canada Gov Debt
(% of GDP)

Country U.K. Netherland N th l d s Norway Sweden Spain Finland Ireland Korea Denmark

Gov Debt
(% of GDP)

173 113 101 92 73 73 71 65 63

59 55 46 45 44 40 33 33 28

TheArithmeticoftheDebtRatio e t et c o t e ebt at o
Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt
Interpretation:

Th h Thechangeinthedebtratioovertimeisequalto i th d bt ti ti i lt thesumoftwoterms. Th fi t t Thefirsttermisthedifferencebetweenthereal i th diff b t th l interestrateandthegrowthratetimestheinitial debtratio. debt ratio Thesecondtermistheratiooftheprimarydeficit toGDP. to GDP

The Arithmetic of the Debt Ratio

Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt
This equation implies that the increase in the ratio of debt to GDP will be larger:

the higher the real interest rate, the lower the growth rate of output, the higher the initial debt ratio, the higher the ratio of the primary deficit to GDP

The Dangers of Very High Debt

Bt Bt 1 Bt 1 (Gt Tt ) (r g ) Yt Yt 1 Yt 1 Yt

The higher the ratio of debt to GDP the larger GDP, the potential for catastrophic debt dynamics. Expectations of higher and higher debt give a hint that a problem may arise, which will lead to the emergence of the p g problem, thereby validating y g the initial expectations. Debt repudiation consists of canceling the debt, in part or in full.

What are the Major Types of Sovereign Debt Defaults?

External Debt Defaults

External debt default: Here a country defaults on its payments to foreign debt holders. When a country runs into a sovereign debt crisis interest rates rise, capital flows stop and the country is thrown into a severe period of economic contraction and fall in living standards. When this happens, the country has a choice of debt repudiation which means it happens reneges on its debt to foreign debt holders entirely or debt restructuring and debt rescheduling which means t at it sits down with its est uctu g a d esc edu g c ea s that t s ts do t ts foreign creditors and negotiates a settlement. Usually, the creditors are forced to take a loss on some portion of the debt, known as a haircut, interest rates are renegotiated towards more favorable terms and external lending resumes The IMF was created in 1945 to assist countries when they run into this type of crisis by extending emergency lending at concessionary rates based on conditionality, conditionality that the government undertakes a specific set of reforms to balance its budget and return the country to financial solvency

What are the Major Types of Sovereign Debt Defaults?

Internal Debt Defaults

Internal debt default: Here a country runs into an inability to service its debts to its citizens but is not forced to default, because the government has the power to print money to service its debts. This results in a rise in unexpected inflation and results in economic stagnation - stagflation The inflation unleashed by the printing of money reduces the real value of the bonds held by debt holders who are its own citizens and thus the government lessens the burden of its debts. Inflation shifts the burden of debt from the l h b d f i d b I fl i hif h b d fd b f h state to its citizens and represents the ultimate form of taxation. The process of unwinding the so ereign debt burden results in a period of n inding sovereign b rden res lts moderate inflation (10% - 20%) and moderate contraction. The Developed world went through such an episode during the 1970s. Today, with central bank independence, it is questionable to what extent central banks will allow independence this to happen without breaching their inflation control mandates. If they resist, interest rates will rise.

Alternatives Methods for Reducing Sovereign Debt Burdens

Currency Depreciation

Currency devaluation or depreciation: When a sovereign debtor is unable to meet its obligations it can resort to currency depreciation. This works when a country is utilizing a flexible currency regime whereby it allows the value of its currency to be determined by demand and supply in the foreign exchange market. Devaluation and depreciation help a country boost its exports and reduce its p p y p imports thereby stimulating domestic economic activity and moderating the contractionary effects on production and employment arising from the debt pressures.

Greece s Greeces Financial Problems

Since joining the euro, Greece has had higher inflation than other Euro zone members. G Greece has also i h l increased d bt f t th others t d debt faster than th to finance generous public sector pay, welfare, and retirement benefits, while collecting a lower share in taxes benefits due to widespread tax evasion. As a result, G ee goods have beco e increasingly s esu , Greek a e become c eas g y expensive and uncompetitive, causing loss of market share and further reducing revenues.

Why has Greece Garnered so much Attention lately?

But because it part of the Euro zone, has given up control of monetary policy and the printing press Since it joined the Euro zone, it has ceded control of monetary policy to the ECB and can no longer print money Wages have risen faster than in Germany and has not adapted its economy rapidly enough to global competition, especially from Asia Two of its largest industries, maritime shipping and tourism were hit strongly from the global economic downturn The Euro zone has not injected the same degree of monetary liquidity as did the UK and the USA while the ECB has maintained a more contractionary monetary stance than the other two central banks The euro has appreciated by about 65% since 2001 against the US Dollar and by 47% against the Chinese Yuan

USD/EUR Exchange Rate Since Greeces Entry Into the Euro zone: 2001 2010 2001-2010
Between January 2001 and January 2010 Euro has appreciated by 65% against the US Dollar, undermining the competitiveness of Greek exports
1.6 1.5 1.4 14 1.3 1.2 1.1 1 0.9 0.8 0.7 07 0.6 2001 2001200120022002200320032004200420052005200620062007200720082008200920092010 2010-12 USD/EUR Exchange Rate USD/EUR Exchange Rate

The Greek Debt Crisis

Greek debt/GDP ratio reached 113% and deficit/GDP ratio reached 12.7% in 2009. Foreign bondholders became doubtful that Greece could continue to roll over its increasing debt forced interest rates higher debt, higher. EU faced choice between Greek default and bailout with tough conditions. IMF and EU agreed to lend Greece up to $146 billion over three years years. Greece to increase sales taxes, reduce public sector salaries, pensions, eliminate bonuses.