Many countries are facing higher public debt to GDP ratios as a consequence of the crisis and some are approaching 100 per cent. Assume the current public debt to GDP ratio is 100 per cent and that central banks keep nominal interest rates and inflation constant and zero. The proponents of fiscal austerity say that by running primary surpluses they can reduce the public debt to GDP ratio even if they create a short-term recession and invoke the automatic stabilisers (which push the budget towards deficit). However, they also claim that it is likely that their strategy will promote growth. The austerity strategy cannot reduce the debt ratio (under our assumptions) if a recession results.
Answer: False
The answer is False.
First, some background.
While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.
The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.
Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.
Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.
It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.
Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be "financed" in two ways: (a) by borrowing from the public; and/or (b) by "printing money".
Neither characterisation is representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector.
Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
The mainstream framework for analysing movements in the public debt ratio is derived from the so-called government budget constraint model (GBC).
For a detailed explanation of this framework see the blogs that are recommended at the end of this answer. I am assuming this knowledge for the rest of the answer.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework (derived from the GBC) focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach:
In English, this can be read as saying that the change in the debt ratio - ΔB/Y (at time t) which is the term to the left of the equals sign - is the sum of two terms on the right-hand side of the equals sign:
The real interest rate is the difference between the nominal interest rate and the inflation rate.
This equation is really derived from an accounting identity and therefore is true by definition, which is not the same thing as saying it has any significance. In Modern Monetary Theory (MMT) playing around with this framework has little significance.
Mainstream economics, however, uses the framework to highlight their claim that running deficits is dangerous. Even progressives who fall into the deficit-dove category use this frameowrk in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time as long as economic growth is strong enough.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
Here is why that is the case.
A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r - g.
Consider this example which is captured in Year 1 in the Table below.
To make matters simple, assume a public debt ratio at the start of the period of 100 per cent (so B/Y(-1) = 1).
Assume that the rate of real GDP growth is minus 2 per cent (that is, the nation is in recession) and the automatic stabilisers push the primary budget balance into deficit equal to 1 per cent of GDP. As a consequence, the public debt ratio will rise by 3 per cent.
The government reacts to the recession in the correct manner and increases its discretionary net spending to take the deficit in Year 2 to 2 per cent of GDP (noting a positive number in this instance is a deficit).
The central bank maintains its zero interest rate policy and the inflation rate also remains at zero.
The increasing deficit stimulates economic growth in Year 2 such that real GDP grows by 2 per cent. In this case the public debt ratio falls by 0.1 per cent.
So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.
The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio - which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.
Now to the specific proposition outlined in the question. Here are the assumptions adopted:
The following Table shows three cases consistent with running primary surpluses:
As a result of modelling the assumptions in the formula (above) we can see that the change in the debt ratio (B/Y) is zero in the event of Case A, falls in the event of Case B (by 1 per cent) and rises in the event of Case C (by 1 per cent).
As long as the primary surplus as a per cent of GDP is exactly equal to the negative GDP growth rate, there can be no reduction in the public debt ratio, under the circumstances (which are the most benign possible).
So it is possible under Case B where the primary budget surplus is 3 per cent (noting that the surplus is presented as a negative figure) and the contraction in real GDP is 2 percent for the debt ratio to fall.
Thus if the "facts" can be achieved, the austerity option can reduce the public debt ratio even if they cause a recession. How likely is it that this would occur in the real world when the government was pursuing such a fiscal path? Answer: unlikely.
First, fiscal austerity will probably push the GDP growth rate further into negative territory which, other things equal, pushes the public debt ratio up. Why? The budget balance is endogenous (that is, depends on private activity levels) because of the importance of the automatic stabilisers.
As GDP contracts, tax revenue falls and welfare outlays rise. It is highly likely that the government would not succeed in achieving a budget surplus under these circumstances.
So as GDP growth declines further, the automatic stabilisers will push the balance result towards (and into after a time) deficit, which, given the borrowing rules that governments volunatarily enforce on themselves, also pushed the public debt ratio up.
So austerity packages, quite apart from their highly destructive impacts on real standards of living and social standards, typically fail to reduce public debt ratios and usually increase them.
So even if you were a conservative and erroneously believed that high public debt ratios were the devil's work, it would be foolish (counter-productive) to impose fiscal austerity on a nation as a way of addressing your paranoia. Better to grit your teeth and advocate higher deficits and higher real GDP growth.
That strategy would also be the only one advocated by MMT.
The following blogs may be of further interest to you:
That is enough for today!