Sunday, August 10, 2014

10/8/2014: Can EU Rely on Large Primary Surpluses to Solve its Debt Problem?

Another paper relating to debt corrections/deflations, this time covering the euro area case. "A Surplus of Ambition: Can Europe Rely on Large Primary Surpluses to Solve its Debt Problem?" (NBER Working Paper No. w20316) by Barry Eichengreen and Ugo Panizza tackle the hope that current account (external balances) surpluses can rescue Europe from debt overhangs.

Note: I covered a recent study published by NBER on the effectiveness of inflation in deflating public debts here:

Eichengreen and Panizza set out their case by pointing to the expectations and forecasts underpinning the thesis that current account surpluses can be persistent and large enough to deflate Europe's debts. "IMF forecasts and the EU’s Fiscal Compact foresee Europe’s heavily indebted countries running primary budget surpluses of as much as 5 percent of GDP for as long as 10 years in order to maintain debt sustainability and bring their debt/GDP ratios down to the Compact’s 60 percent target." More specifically: "The IMF, in its Fiscal Monitor (2013), sketches a scenario in which the obligations of heavily indebted European sovereigns first stabilize and then fall to the 60 percent level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. The heavier the debt, the higher the interest rate and the slower the growth rate, the larger is the requisite surplus. The average primary surplus in the decade 2020-2030 is calculated as

  • 5.6 percent for Ireland, 
  • 6.6 percent for Italy, 
  • 5.9 percent for Portugal, 
  • 4.0 percent for Spain, and 
  • (wait for it…) 7.2 percent for Greece."

It is worth noting that Current Account Surpluses strategy for dealing with public debt overhang in Ireland has been aggressively promoted by the likes of the Bruegel Institute.

These are ridiculous levels of target current account surpluses. And Eichengreen and Panizza go all empirical on showing why.

"There are  both political and economic reasons for questioning whether they are plausible. As any resident of California can tell you, when tax revenues rise, legislators and their  constituents apply pressure to spend them." No need to go to California, just look at what the Irish Government is about to start doing in Budget 2015: buying up blocks of votes by fattening up public wages and spending. Ditto in Greece: "In 2014 Greece, when years of deficits and fiscal austerity, enjoyed its first primary surpluses; the government came under pressure to disburse a “social dividend” of €525 million to 500,000 low-income households ... Budgeting, as is well known, creates a common pool problem, and the larger the  surplus, the deeper and more tempting is the pool. Only countries with strong political and budgetary institutions may be able to mitigate this problem (de Haan, Jong-A-Pin and Mierau 2013)."

More significantly, Eichengreen and Panizza show that "primary surpluses this large and persistent are rare. In an extensive sample of high- and middle-income countries there are just 3 (non-overlapping) episodes where countries ran primary surpluses of at least 5 per cent of GDP for 10 years." These countries are: Singapore (clearly not a comparable case to Euro area countries), Ireland in the 1990s and New Zealand in the 1990s as well.

"Analyzing a less restrictive definition of persistent surplus episodes (primary surpluses averaging at least 3 percent of GDP for 5 years), we find that surplus episodes are more likely when growth is strong, when the current account of the balance of payments is in surplus (savings rates are high), when the debt-to-GDP ratio is high (heightening the urgency of fiscal adjustment), and when the governing party controls all houses of parliament or congress (its bargaining position is strong). Left wing governments, strikingly, are more likely to run large, persistent primary surpluses. In advanced countries, proportional representation electoral systems that give rise to encompassing coalitions are associated with surplus episodes. The point estimates do not provide much encouragement for the view that a country like Italy will be able to run a primary budget surplus as large and persistent as officially projected."

Good luck spotting such governance institutions in the euro area 'periphery' nowadays. "Researchers at the Kiel Institute (2014) conclude that “assessment of historical developments in numerous countries leads to the conclusion that it is extremely difficult for a country to prevent its debt from increasing when the necessary primary surplus ratio reaches a critical level of more than 5 percent.”"

Eichengreen and Panizza take a sample of 54 emerging and advanced economies over the period 1974-2013. They show that "primary surpluses as large as 5 percent of GDP for as long as a decade are rare; there are just 3 such non-overlapping episodes  in the sample. These cases are special; they are economically and politically idiosyncratic in the sense that their incidence is not explicable by the usual economic and political correlates. Close examination of the three cases suggests that their experience does not scale."

As mentioned above, one case is Ireland, starting from 1991. "Ireland’s experience in the 1990s is widely pointed to by observers who insist  that Eurozone countries can escape their debt dilemma by running large, persistent primary surpluses. Ireland’s move to large primary surpluses was taken in response to an incipient debt crisis: after a period of deficits as high as 8 per cent of GDP, general government debt as a share of GDP reached 110 per cent in 1987. A new government then slashed public spending by 7 per cent of GDP, abolishing some long-standing government agencies, and offered a one-time tax amnesty to delinquents. The result was faster economic growth that then led to self-reinforcing favorable debt dynamics, as revenue growth accelerated and the debt-to-GDP ratio declined even more rapidly with the accelerating growth of its denominator. This is a classic case pointed to by those who believe in the existence of expansionary fiscal consolidations (Giavazzi and Pagano 1990). But it is important, equally, to emphasize that Ireland’s success in running large primary surpluses was supported by special circumstances. The country was able to devalue its currency – an option that is not available to individual Eurozone countries – enabling it sustain growth in the face of large public-spending cuts by crowding in exports. As a small economy, Ireland was in a favorable position to negotiate a national pact (known as the Program for National Recovery) that created confidence that the burden of fiscal austerity would be widely and fairly shared, a perception that helped those surpluses to be sustained. (Indeed, it is striking that every exception considered in this section is a small open economy.) Global growth was strong in the decade of the
1990s (the role of this facilitating condition is emphasized by Hagemann 2013). Ireland, like Belgium, was under special pressure to reduce its debt-to-GDP ratio in order to meet the Maastricht criteria and qualify for monetary union in 1999. Finally, the country’s multinational-friendly tax regime encouraged foreign corporations to book their profits in Ireland, which augmented revenues."

The point of this is that "Whether other Eurozone countries – and, indeed, Ireland itself – will be able to pursue a similar strategy in the future is dubious. Thus, while Irish experience has some general lessons for other countries, it also points to special circumstances that are likely to prevent its experience from being generalized."

Another country was New Zealand, starting with 1994. "New Zealand experienced chronic instability in the first half of the 1980s; the budget deficit was 9 percent of GDP in 1984, while the debt ratio was high and rising. Somewhat in the manner of Singapore, the country’s small size and highly open economy heightened the perceived urgency of correcting the resulting problems. New Zealand therefore adopted far-reaching and, in some sense, unprecedented institutional reforms. At the aggregate level, the Fiscal Responsibility Act of 1994 limited the scope for off-budget spending and creative accounting. It required the government to provide Parliament with a statement of its long-term fiscal objectives, a forecast of budget outcomes, and a statement of fiscal intentions explaining whether its budget forecasts were consistent with its budget objectives. It required prompt release of aggregate financial statements and regular auditing, using internationally accepted accounting practices. At the level of individual departments, the government set up a management framework that imposed strong separation between the role of ministers (political appointees who specified departmental objectives) and departmental CEOs (civil servants with leeway to choose tactics appropriate for delivering outputs). This separation was sustained by separating governmental departments into narrowly focused policy ministries and service-delivery agencies, and by adopting procedures that emphasized transparency, employing private-sector financial reporting and accounting rules, and by imposing accountability on technocratic decision makers (Mulgan 2004). As a result of these initiatives, New Zealand was able to cut public spending by more than 7 per cent of GDP. Revenues were augmented by privatization receipts, as political opposition to privatization of public services was successfully overcome. The cost of delivering remaining public services was limited by comprehensive deregulation
that subjected public providers to private competition. The upshot was more than a decade of 4+% primary surpluses, allowing the country to halve its debt ratio from 71 per cent of GDP in 1995 to 30 per cent in 2010."

Agin, problem is, New Zealand-style reforms might not be applicable to euro area countries. Even with this, "it is worth observing that it took full ten years from the implementation of the first reforms, in 1984, to the emergence of 4+% budget surpluses in New Zealand a decade later."

Key conclusion of the study is that "On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected." Which leaves us with the menu of options that is highly unpleasant. If current account surpluses approach to debt-deflation fails, and if inflation is not a solution (as noted here: then we are left with the old favourites: debt forgiveness (not likely within the euro area), foreign aid (impossible within the euro area on any appreciable scale), or debt restructuring (already done several times and more forthcoming - just watch Irish Government 'early repayment' of IMF loans).

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