Media Briefings

FISCAL LIMITS: Cross-country differences in the level at which public debt is out of control

  • Published Date: March 2015

New research on the highest public debt that a selection of countries could repay – their ‘fiscal limits’ – warns of an Italian debt crisis. The study by Betty Daniel and Christos Shiamptanis, to be presented at the Royal Economic Society’s 2015 annual conference, finds that Italy became ‘at risk’ in 2012. Greece and Portugal became ‘at risk’ in 2008 and 2009, respectively – and both countries lost access to markets two years later. In contrast, Belgium, Canada and France are not ‘at risk’ of a debt crisis.

This study uses historical data on primary surpluses (surpluses excluding interest payments) and debt relative to GDP for six high-debt, developed countries, two of which lost access to markets after the 2007-2009 financial crisis, to estimate the behaviour of the primary surplus in response to changes in debt.

The researchers explore why Greece lost access to credit markets when debt exceeded 130% of GDP, whereas Belgium successfully handled identical debt relative to GDP. They find that the fiscal limits on debt were between 130% and 149% of GDP for Greece and between 94% and 108% of GDP for Portugal.

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Greece lost access to credit markets when debt exceeded 130% of GDP, whereas Belgium successfully handled identical debt relative to GDP. What determines the highest debt that a country could repay, defined as its ‘fiscal limit’? Can we estimate the fiscal limit for a country that has never lost access to markets?

This study uses historical data on primary surpluses (surpluses excluding interest payments) and debt relative to GDP for six high-debt, developed countries, two of which lost access to markets after the 2007-2009 financial crisis, to estimate the behaviour of the primary surplus in response to changes in debt.

The amount by which governments increase the primary surplus, using spending cuts and/or tax hikes, in response to an increase in debt is a key behaviour in determining whether fiscal policy is sustainable. As debt rises, the primary surplus must rise sufficiently to prevent debt from spiralling out of control.

Ghosh et al (2013) estimate primary surplus responsiveness to debt using a large panel model and find that responsiveness depends on the value of debt. They argue that at high values of debt, surplus responsiveness continues to fall as debt rises, a phenomenon that the authors term ‘fiscal fatigue’. Fiscal fatigue provides information about a fiscal limit since there is a value of debt beyond which surplus responsiveness becomes too small for fiscal sustainability.

This study challenges the concept of fiscal fatigue. If responsiveness is increasing in the interest rate and not in debt, then the reduced responsiveness that Ghosh et al find at high debt values could occur because, in the sample, debt reached high values just as the interest rate fell.

The estimates in this study confirm that responsiveness is increasing in the interest rate. Responsiveness is highest in the period when interest rates are highest. Responsiveness falls later in the sample as interest rates fall, for all countries, whether their debt rises or falls.

Next, the researchers use their estimates prior to 2009 to compute the expected path of debt in the aftermath of the financial crisis. They find that Greece and Portugal, two countries that lost access to the markets, deviated from their expected trajectory by more than 30%, whereas Belgium, Canada, France and Italy deviated on average by 10%. But are the latter four countries approaching their fiscal limits?

The researchers’ procedure does not provide an estimate for a country’s fiscal limit, but it provides information about the fiscal limit’s lower bound. First, the estimates yield a value for debt in the long run. When a country is able to borrow, agents must believe that the fiscal limit is above the long-run value of debt.

Second, since there were no defaults in this set of countries between 1970 and 2008, then each country’s fiscal limit must be above the maximum value of debt observed in the sample period. The largest of these two debt measures constitutes a lower bound on the fiscal limit.

The study uses this lower bound together with the projected path of debt to determine the countries ‘at risk’ for a debt crisis. It finds that Greece and Portugal became ‘at risk’ in 2008 and 2009, respectively. Both countries lost access to markets two years later. Fiscal limits on debt were between 130% and 149% of GDP for Greece and between 94% and 108% of GDP for Portugal.

In addition, the results warn of an Italian debt crisis. The study finds that Italy became ‘at risk’ in 2012. In contrast, Belgium, Canada and France are not ‘at risk’ for a debt crisis.

ENDS


Fiscal Rules and Fiscal Limits
Betty Daniel
Christos Shiamptanis