Malta: Public Debt - How Dangerous Is It?

Last Updated: 11 January 2013
Article by Steve Stivala

The issue of the national debt stock has become a recurring theme in news headlines nowadays, particularly since peripheral countries of the Euro zone are being directed to a cul-de-sac of fiscal austerity aimed at reducing public debt levels. Many Eurozone countries have exceeded the 60% threshold as stipulated in the Stability and Growth Pact, including EU stalwarts like France and Germany with gross debt levels at 90% and 83% of GDP respectively. Other peripheral countries, most notably Greece, Ireland, Italy and Portugal have amassed national debt exceeding their level of GDP. This gives the illusion that national debt is the primary cause of the economic distress being experienced today, and that fiscal austerity is the only sustainable and effective way of reducing the stock of national debt. However, it is not apparent that there exists a clear cut threshold where debt levels start to get worrisome (in fact, both the 60% Stability and Growth Pact threshold, and the 100% benchmark were arbitrarily determined). Indeed, the United States carries no less than 108% of GDP in national debt, which is more than the combined EU national debt (taken in aggregate). Yet, the United States does not find itself in half the economic mess of the Eurozone, principally because the United States has a centralised fiscal budget which can be used to correct asymmetries (still, the prospect of going over the fiscal cliff is a tangible and dangerous one for the U.S.).

The key is to look at the circumstances of the economic climate, and the available tools to address such issues. Whilst here we are not advocating that excessive debt levels are not a problem, since they generally lead to systemic economic malaise, one must tread cautiously in interpreting the numbers and avoid drawing hasty conclusions. In this section, we hope to address a few questions surrounding public debt, and dispel some common misconceptions which are often communicated by journalists and politicians alike.

Why worry about public debt?

There is the ill-fated tendency to consider any level of public debt as a malignant carbuncle on the face of a nation's socio-economic scenario. Indeed, the word 'debt' has become loaded with negative connotations, especially in political parlance. This is unfortunate since even a balanced budget (or a budget surplus) can be a sign of poor fiscal management. On the other hand, running budget deficits in times of economic hardships can be both welcome and commendable.

The analogy with obesity, as articulately postulated by Martin Feldstein in 2004 , perfectly captures the rationale of public debt. Like obesity, public debt is also the result of over-indulgence, or living beyond one's needs. However, it is easy to postpone a remedy as its effects are not immediate.

They are felt slowly but surely. This 'time-inconsistency' dispels any sense of urgency in dealing with the problem, although there clearly is a problem if your weight is increasing year on year. Alas, just like obesity, the greater the problem, the harder it becomes to correct – the economy, just like an obese person, would be inundated with high interest payments and low economic growth, making it harder to revert to a sustainable path.

Clearly, this leads to the question concerning the appropriate size of national debt. Just like the ideal weight of an individual is a complex and subjective issue, the debt counterpart carries the same fate. However, one thing is certain. If the national debt is on an ever increasing path, something is wrong and something needs to be done to have it corrected.

In this context, it might be tempting to regard as self-evident the fact that high public debt is the cause of soaring unemployment, rampant inflation and financial market panic. After all, the situation in Greece and Spain points towards that conclusion. However, examining both theory and statistical evidence, the economic causative channels become less obvious.

If one takes a look at the theory and heated debate surrounding public debt throughout the past century, one would notice that the theory keeps changing in the light of new evidence which reinforces old thinking. In fact, whilst classicists before John Maynard Keynes regarded national debt as a burden, possibly preached in the historical context of attempting to curb the power of the irresponsible monarch, Keynesians writing against the backdrop of the Great Depression advocated fiscal intervention, and therefore borrowing, to restore employment. In this sense, government borrowing was seen as a compensatory fiscal tool which stimulated the economy. The only cost to this borrowing was considered to be in the form of long-term private investment crowding out . In this respect, governments were seen as reducing the capacity of the private entrepreneur to raise finance and denting the appetite to invest in projects (hence crowding out). However, this assumes that government spending, fuelled through borrowing, is unproductive investment. Whilst this may be true if such debt is financing welfare payments or excessive civil servant wages, this assertion might not hold if debt is utilised in building infrastructure, or financing recurrent expenditure which reinforces the capital stock of the economy, such as expenditure in health and education. Government expenditure of this sort, even if financed through borrowing, can hardly be labelled as a debt of current and future generations.

The debate about public debt was re-ignited in the late seventies and eighties by Barro which saw a resurgence of Ricardo's theory claiming that government expenditure does not constitute a burden, irrespective of how it is financed, either through taxation or borrowing. The rationale of the Ricardian Equivalence theory stems from the assumption of rational expectations, in that rational taxpayers alter their behaviour accordingly. If government raises finance through borrowing, citizens increase their savings in anticipation of future increases in tax rates (to pay off maturing debt). The interplay of increased individual savings and issued government debt exactly offsets any changes in interest rates. The bottom line is that, with interest rates unchanged, crowding out does not occur and the debt/tax ratio becomes irrelevant.

Needless to say, this revived theory came under heavy fire, suffering a scathing attack, particularly on its simplistic assumptions of rational expectations, infinite horizons and liquidity constraints. Whilst this is not the place to discuss the intricacies of the economic theory, it does provide an indication of the dynamics of economic debate. Further exacerbating the issue at hand is that empirical estimation of such theories is not uncontroversial to say the least.

The burden of the national debt

It might be tempting to put forward the analogy of private debt when trying to explain the concept of national debt. Just like a private debtor, there is the popular prejudice that national debt signifies impoverishment and ruin. For the private debtor, this is perfectly logical as borrowing today to consume beyond one's means would result in a reduction in consumption in the future to pay off the debt. In reality, this is akin to borrowing real resources from the future. However, this does not extend to national debt, as the transferability of this analogy is denied by nearly all economists as a fallacious argument.

The two differ in that a private debtor owes money to an external individual. In the case of a nation, when the debt is held internally, we owe it to ourselves. In this respect, there is no burden to society in so far as the debt is not foreign. It is also commonplace to make the fallacy with respect to inter-generational burden. It is rather deceptively intuitive to think that if debt is amassed today, future generations would be burdened by such debt. What we fail to realise however, is that the payments of matured bonds, with interest, would be made to future generations as well. One would be quick to point out that the major flaw in the 'we owe it to ourselves' argument is that 'we' does not equate to 'ourselves' in the sense that holders of government debt are not the ones who pay the taxes to pay off such debt. This is true. However, if burden is defined this way, then this burden is not worse off than the burden created by raising taxes. It is, for all intents and purposes, a redistribution of wealth on both accounts.

Here, we must reiterate that what is being said is not that internal debt, however large, is innocuous. On the contrary, rampant internal debt may introduce adverse conditions on the economy such as inflation, increases in distortionary taxation, and a cut in productive public spending. Nevertheless, such debt has been a victim of semantic hyperbole and misinformed debate, and one must correctly frame the problem to address it in proportionate doses.

What about international debt?

On the flipside, it is widely acknowledged that foreign debt does confer a burden on the nation incurring such debt in the sense that external borrowing allows a country to consume more than it produces at present. However, this must be repaid in the future, and therefore future consumption must decrease. Whether this burden constitutes an intergenerational burden and whether it impoverishes future generations is also the subject of debate. What is clear though, is that foreign debt presents a more pernicious scenario in the form of interest payment leakage and reductions in National Income. The situation is made much worse if capital markets require even higher interest rates (to counter the risk of default), making actual default more likely especially since a burdensome foreign debt reduces the economy's capacity to grow. Fortunately in Malta, the public debt composition is biased in favour of locally held debt. Indeed, 91% of the total government debt stock held as at October 2012 was in the form of Malta Government Stocks (MGS) which is primarily (save for a couple percentage points) subscribed to by local businesses and residents.

Determinants of public debt

So far we have talked about some of the effects of public debt, but we have not really pinpointed the determinants of public debt and how it changes in relation to other variables. A simplistic but useful approach is to identify the variables that have a bearing on the change in the national debt. The four key variables are the Primary Balance (Government revenues less expenditure), the nominal interest rate, inflation and economic growth.

In general, an increase in the nominal interest rates and a negative primary balance spell disaster for a heavily indebted country due to dynamic interlinkages. In other words, more borrowing (negative primary balance) induce interest rates to rise (due to an increase in perceived risk) causing the debt to balloon further. On the other hand, economic growth and inflation are negatively correlated to public debt. Since the debt is expressed as a percentage of GDP, an increase in GDP would reduce the debt to GDP ratio, with the economy poised to generate more income in paying off the debt. With respect to inflation, an increase in the general price level would erode the real value of the debt and therefore inflation is generally welcome by heavily indebted governments. However, the nominal interest rate would react upwards as lenders expect a compensation for the real loss in their asset value.

What can be done to reduce debt? Way forward.

Having discussed the perils of huge piles of debt, it is perhaps understandable that policy makers around the world are seeking for the appropriate policy mix to fire fight the impending danger. Unfortunately, there is no right or wrong policy as one has to take into consideration the environment in which policy is applied and the causal relationship of variables.

By far, the most simple and direct measure to curb further growth of debt is to aim for a positive primary balance (raising taxes and cutting government expenditure). This is evident throughout the developed world, with Europe enduring harsh austerity measures, and the U.S. nearing the fiscal cliff as expansionary measures are set to automatically expire at year end. However, solely addressing the primary balance can be self-defeating as tax increases and spending cuts generally lower economic growth. With an economy in recession, the debt to GDP ratio expands, putting further pressure on interest rates to rise. This is, in effect, a reinforcing downward spiral.

Attempting to learn from history, the IMF recently published a study which looks at twenty six episodes of high debt from 1875 onwards when the national debt exceeded the 100% mark. Astonishingly, whilst economic growth, spending cuts and tax increases had a marginal impact, it was monetary policy which had the lion's share of the impact, particularly low interest rates and inflation. Without these necessary conditions, consolidation was doomed to fail. This is rather good news for the U.S and the U.K but not so much for the EU. While the former can slash interest rates and/or engage in quantitative easing, the EU lacks the manoeuvrability to do so. Apart from the fact that the ECB cannot monetise the debt, there is the added problem of country idiosyncrasies, which respond differently to a 'one-size fits all' monetary policy, and the lack of a central budget. In this respect, EU countries can respond only through local deflation, not devaluation, and via austerity measures, not through inflation. This restricts growth, makes it harder to reduce debt, and makes the pill even harder to swallow.

Public debt and competitiveness: is there a link?

The dangers of an ever-increasing public debt are well documented in economic literature, and this has been one of the main focal points of EU policy for some time. In particular, the main concern is that sovereign default, especially in ailing peripheral EU countries, may lead to a systemic effect across the whole continent, damaging investor confidence and leading to further economic contractions. So how does a rise in public debt affect competitiveness?

First, higher public debt levels would most probably lead to an increase in interest rates since the governments would need to offer higher returns to attract further capital. This has two effects, in that it increases the cost of raising finance, and it crowds out private investment, both of which are crucial for competitiveness and growth.

Secondly, it is important to consider where the debt-financed spending is directed at. If it is financing investment (in healthcare or education) then it is safe to assume that this would enhance the long-term growth potential of the economy. If on the other hand, it is financing current consumption, then the economy might not grow fast enough to be able to repay its future debts.

Lastly, even if the problem of a ballooning public debt is identified and targeted, governments would need to address it by raising taxes or cutting public expenditure. Specifically, raising taxes may stifle investment. Furthermore, spending cuts are usually directed towards activities which promote innovation and investment, notably R&D. This may erode long term competiveness at the expense of solving short-run financial difficulties.

This article was originally published in Insight 2012. Please click here to view the original document.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Steve Stivala
 
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