Most economists would agree that high government debt doesn’t necessarily lead to an economic downturn – the sharp rise in Eurozone government debt in 2008–15 was a consequence, rather than the cause, of the Great Financial Crisis (GFC). But excessive credit tends to be a drag on economic growth and can be a constraint on fiscal policy.
According to a research paper by Carmen Reinhart and Kenneth Rogoff, over the past two centuries government debt in excess of 90% of GDP in advanced economies has typically been associated with economic growth, on average, of 1.7%. This compares with 3.0%–3.7% growth, on average, when debt is below 90% of GDP.
In the Eurozone the government debt/GDP ratio rose, on average, from 65% in 2007 (i.e. before the GFC) to 85% in 2018. But there are big divergences between, for example, Germany on the one hand (60% and shrinking) and Italy, France and Spain on the other (close to, or above, 100% of GDP).
So, what can be done to bring down these high debt levels?
There are four ways to reduce a country’s government debt-to-GDP ratio; two by lowering the numerator and two by raising the denominator. Unfortunately, all four have their drawbacks.
First, a country can reduce its outstanding debt (i.e. lower the numerator) through fiscal austerity. The problem with this is that it can be pro-cyclical in the short term (i.e. belt-tightening when economic growth is slowing), while the efficacy is subject to considerable debate, especially in Europe (think of the Maastricht Treaty’s contentious debt and budget deficit limits).
Second, a country can simply decide not to pay off its debt, i.e. to default. But as Greece showed in 2011-12, this is easier said than done, especially in a currency union, not least because it involves known unknowns such as risky feedback loops between sovereigns and banks.
Third, governments can stimulate real GDP growth (i.e. raise the denominator) through structural economic reforms. This is effective in the long run, but economically painful and politically difficult in the short run. The ‘gilets jaunes’ movement against French President Emmanuel Macron’s reforms springs to mind here.
Fourth, a country can try and boost nominal GDP growth by raising inflation. This is what the ECB has been trying to do, desperately, by means of asset purchases, also known as quantitative easing (QE). This policy has boosted nominal growth over the past few years, although the impact has been modest compared to what it has done to asset price inflation. Eurozone core consumer price inflation is still well below the ECB’s targeted 2%.
Although the fourth option – exceedingly loose monetary policy – comes with unintended consequences, such as rising inequality, misallocation of capital, asset bubbles and moral hazard, it looks like the least painful way to lower the government debt/GDP ratio.
As a consequence, low interest rates in the Eurozone are here to stay for as long as inflation stays low, which is likely to be a long time, in my view. Will the ECB’s exceedingly easy monetary policy continue to support equity markets to the same extent as it has in the past ten years? I have my doubts, but that is a story for another day.
Author: Bert Jansen, Strategist