The Eurozone countries will only start to reduce their public debt ratio when the respective governments succeed in running primary budget surpluses (that is, spending net of interest payments is less than taxation revenue).
Answer: False
The answer is False.
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 always rise when there are deficits.
But the rising debt levels do not necessarily have to rise at the same rate as GDP grows. The question is about the debt ratio not the level of debt per se.
Rising deficits often are associated with 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.
The mainstream framework for analysing the dynamics in public debt ratios starts with the concept of the government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments - Tax receipts must equal (be "financed" by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
However, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been correctly added and subtracted.
For a sovereign government that issues its own currency, the previous equation is just an ex post accounting identity that has to be true by definition and has no real economic importance.
However, for nations such as Greece, which has ceded its currency sovereignty, the GBC becomes an financial constraints given that it has to fund its spending from taxation and/or bond issues.
A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The standard mainstream framework is usually expressed in terms of the ratio of debt to GDP rather than the level of debt per se. Even so-called progressives (deficit-doves) use this framework as if it applies to all governments.
The following equation captures the approach:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
The real interest rate is the difference between the nominal interest rate and the inflation rate.
This standard mainstream framework is used to highlight the dangers of running deficits. But even progressives (not me) use it in a perverse way to justify deficits in a downturn balanced by surpluses in the upturn.
Many mainstream economists and a fair number of so-called progressive economists say that governments should as some point in the business cycle run primary surpluses (taxation revenue in excess of non-interest government spending) to start reducing the debt ratio back to "safe" territory.
Almost all the media commentators that you read on this topic take it for granted that the only way to reduce the public debt ratio is to run primary surpluses. That is what the whole "credible exit strategy" rhetoric is about and what is driving the austerity push around the world at present.
So the question is whether continuous national governments deficits imply continuously rising public debt levels as a percentage of GDP and whether primary budget surpluses are required to reduce the public debt ratio.
While MMT advocates running budget deficits when they are necessary to fill a spending gap left by non-government saving, it also emphasises that a government running a deficit can also reduce the debt ratio if it stimulates growth.
The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time.
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.
The orthodox economists use this analysis to argue that permanent deficits are bad because the financial markets will "penalise" a government living on debt. If the public debt ratio is "too high" (whatever that is or means), markets "lose faith" in the government.
Consider the following Table which shows two years in the life of an economy.
It keeps things simple by assuming a public debt ratio at the start of the period of 100 per cent (so B/Y(-1) = 1).
Assume that the real rate of interest is 0 (so the nominal interest rate equals the inflation rate) - not to dissimilar to the situation at present in many countries.
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. So in Year 2, the debt ratio is 1.03 of GDP.
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 so the real interest rate doesn't move.
The increasing deficit stimulates economic growth in Year 2 such that real GDP grows by 3 per cent. In this case the public debt ratio falls by 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.
In other words, a government such as Greece does not have to run budget surpluses to bring its public debt ratio down. What it needs is growth and that is more likely to occur if it holds its nerve and runs deficits. The problem is that the membership of the EMU (lack of currency sovereignty) makes that difficult without ECB support.
The best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn't have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.
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.
The following blog may be of further interest to you: