European sovereign debt: understanding the numbers Researchers in academia and policy institutions, politicians, journalists, business managers… everyone in Europe keeps an eye nowadays on the evolution of public debt as a share of GDP. Movements of this indicator can induce big stress in financial markets and painful policy responses. But what does this ratio exactly mean? Useful as it is, it also leaves aside many relevant issues. This article describes some keys to understand what the debt-to-GDP ratio exactly means and where its limitations lie. As the European debt crisis has developed, European countries have become increasingly conscious of the need to keep national sovereign finances under control. Otherwise, the common project of a currency and monetary union has shown itself as rather dysfunctional. Consequently, the Fiscal Stability Treaty (also known as “Fiscal Compact”) entered into force in 2013 to enhance provisions from the Stability and Growth Pact. In particular, steps were taken to apply preventive and corrective fiscal measures (including disciplinary penalties) more consistently than in the past. The Excessive Deficit Procedure (EDP) is launched when one or both of the following rules are breached by a Member State: the deficit must not exceed 3% of GDP and public debt must not exceed 60% of GDP (or at least diminish sufficiently towards this value). Simultaneously, researchers in academia and institutions have debated more intensely about the effects of high sovereign debt on output growth. The damaging effects for debt levels higher than 85 or 90% of GDP – claimed by Reinhart and Rogoff (2010), Kumar and Woo (2010) and Cecchetti, Mohanti and Zampolli (2011), among others – brought renewed interest in the share of debt to GDP. This ratio probably became a “trending word” in the economic blogosphere after Herndon, Ash and Pollin published in April 2013 a strong critique of the methodology and results of Reinhart and Rogoff’s work.
EYES ON EUROPE
Juan Equiza
Despite considering it very interesting and necessary, it is not the purpose of this article to debate further the effects of high debt on growth; neither the effectiveness of rules like the ones incorporated in the “Fiscal Compact”. The analysis focuses instead on this indicator that – in one way or another – has always been involved in the discussion: the debtto-GDP ratio. My objective is to explain the meaning of this number as a useful (but rather simplistic) indicator of the government’s solvency, as well as its limitations. But our government’s ability to pay creditors back depends also on the size of our country’s future wealth and, consequently, debt figures should be “read” in relative terms.
First of all, understanding the economic implications of debt figures by looking at them in absolute terms is quite difficult. If we worry about the size of government debt – better said, if our creditors are concerned about the size of our government debt – it is because higher debt lowers future wealth available for repayment. But our government’s ability to pay creditors back depends also on the size of our country’s future wealth and, consequently, debt figures should be “read” in relative terms. Therefore, ideally, a country’s future payment obligations should be compared with disposable future government income. However, to avoid obtaining values for the latter – which is much more complicated than for the former –, we would like to approximate it by using current government income, or just some measure of national income, like GDP. So, as one can see, we sacrifice conceptual
ECONOMY & SOCIAL
rigour for the benefit of using a wellconstructed measure, as it is the case of GDP. Regarding the numerator – government debt – we find that choosing an easily quantifiable measure implies leaving aside relevant information. To begin with, notice that the concept of government needs to be defined explicitly. For EDP, it is the debt of the general government that matters; that is, it includes debt issued by central, state and local government levels, as well as Social Security funds. Since it is possible that the liabilities issued by one government level are held by another, the Euro area institutions monitor consolidated debt figures. As a result, debt instruments that are simultaneously a liability for one government level and an asset for another are excluded because they do not represent an obligation of government in general with other sectors of the economy. A typical example is when Social Security funds invest their savings in central government treasury bonds. However, this consolidating practice is not exempt of criticism because the savings of Social Security funds come from receipts that pay future (partly accrued) pensions. And the latter constitutes a commitment that – although not explicitly made by law or contract – contributors expect to be honored. The Eurostat/ECB Task Force on Pensions estimates that accrued-to-date pension entitlements in the Euro area are already over 300% of GDP. Nevertheless, our pay-as-you-go social security systems require that this impressive figure be paid for with future contributions and therefore it is excluded from the EDP debt concept. Economists look at two concepts of general government (consolidated) debt: gross and net debt. EDP provisions refer to the gross concept, which is the stock of outstanding government debt in the form of mainly securities and loans. Net debt is the difference between gross debt and the financial assets that
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