Institutional arrangements and public debt threshold limits

Abstract

Inter-governmental Organisations, such as the IMF and OECD, advocate a medium-term reduction in deficit spending and public debt accumulation among advanced economies to satisfy conditions of fiscal sustainability. Buttressing the need for fiscal austerity, Reinhart and Rogoff claim to have identified a so-called tipping point, beyond which public debt accumulation negatively affects economic growth. While recent data seem to indicate that some Eurozone (non-sovereign) economies have reached a tipping point, for other advanced (sovereign) economies, such as the US, UK and Japan, this is not clear. The mainstream tipping point literature however does not recognise the importance of institutional arrangements for the conduct of fiscal and monetary policy. Furthermore, the literature sheds little light on the transmission mechanism between high public debt and low economic growth. This article draws on the principles of Modern Monetary Theory to discuss institutional arrangements and to justify the theoretical and empirical focus on Eurozone economies. The empirical analysis unpacks the transmission mechanism(s) to reveal that Eurozone economies have reached a public debt threshold limit with respect to long-term interest rates.

Keywords:

• threshold effect
• government policy
• interest rates
• EMU

JEL Classifications:

• C33
• E62
• H6

Acknowledgements

Special thanks to Martin Watts. The author is also thankful to Malcolm Sawyer and two anonymous referees for helpful comments on earlier drafts. Any remaining errors are the author’s.

Notes

1. Fiscal sustainability is typically defined with reference to the algebra of debt dynamics. For example, assuming a positive real (average) interest-growth rate differential, fiscal sustainability implies the present value of future primary budget surpluses to GDP must equal the initial debt to GDP ratio (see Watts and Sharpe forthcoming). Price (2010, 5) defines a sustainable fiscal balance as ‘the issue of debt to finance government expenditure only to the extent that it creates a future debt burden that does not interfere with the attainment of macro-economic objectives.’ Eurozone members are subject to formal fiscal requirements detailed in the Treaty, including the recently strengthened Stability and Growth Pact (see Troika 2011).

2. Herndon, Ash, and Pollin’s (2013, 2–3) attempt to replicate Reinhart and Rogoff’s (2010) findings revealed that ‘coding errors, selective exclusion of available data, and unconventional weighting of summary statistics lead to serious errors that inaccurately represent the relationship between public debt and growth among 20 advanced economies in the post-war period.’ Herndon, Ash, and Pollin’s (2013, 3) conclude that ‘when properly calculated, the average real GDP growth rate for countries carrying a public debt-to-GDP ratio of over 90 percent is actually 2.2 percent, not –0.1 percent as [Reinhart and Rogoff] claims.’ Reinhart and Rogoff (2013) provided a brief and somewhat dismissive response to this criticism in The Wall Street Journal. Empirical errors aside, there are deeper theoretical flaws within Reinhart and Rogoff’s (2010) approach and indeed the broader mainstream literature investigating public debt threshold limits. This article attempts to address these issues.

3. ‘[N]eoliberalism can best be understood [as] an economic policy regime whose objective is to secure monetary and fiscal stability and that is legitimised by an ideology that holds markets are best treated as self-regulating’ (Callinicos 2012, 67). The Washington Consensus offers a useful short-hand description of neo-liberal policy prescriptions (see Williamson 1990).

4. Fiscal space is the residual capacity a government has to respond to uncertainties within the economic environment net of its intertemporally defined sustainable fiscal position (see Heller 2005; IMF 2012a). Fiscal space is allegedly created by a fiscal consolidation, efficient allocations of government expenditure, issuing public debt, or high-powered non-interest bearing money creation (Heller 2005).

5. Note that the notion of ‘sovereign risk premium’ refers to risk premiums on public debt instruments without differentiating between economies that enjoy full monetary-fiscal sovereignty and economies that do not.

6. Popular case studies of expansionary fiscal contractions include Denmark, Ireland, Sweden and Finland. Perotti (2011) notes that interest rates decreased significantly in these cases.

7. Monaghan (2012) notes, ‘George Osborne [incumbent UK Chancellor of the Exchequer] has repeatedly insisted he will not deviate from the £123bn of austerity planned over seven years, arguing that a clear and credible deficit reduction target has protected Britain’s AAA credit rating and ensured low interest rates.’

8. In opposition to government policies, bond market investors may sell bonds or demand higher risk premiums, which increase bond yields.

9. Monetary independence allows for (Central Bank) discretion vis-à-vis directing interest rate policy towards exchange rate concerns and engaging in open-market-operations.

10. The use of government debt to control the cash rate given a ‘corridor’ system is explicit within the Reserve Bank of Australia’s market operation notes (see RBA 2012). See also Watts (2012).

11. National currency denominated government debt (i.e. in a sovereign economy) is often considered to be a (default) risk-free interest-bearing asset. However there are other dimensions of risk which may be relevant (e.g. exchange rate risk and inflation risk).

12. To secure a bailout arrangement with the IMF/EC/ECB, Greek officials approved an austerity plan that reduces the minimum wage by 22%, and cuts pensions and 150,000 public sector jobs (see Papadimas and Papachristou 2012).

13. Quantitative easing measures in advanced sovereign economies may have contributed to low long-term bond yields (e.g. the UK; see Joyce and Tong 2012). Individual Eurozone economies do not have the capacity to implement such measures.

14. The authors have recently extended their previous work to include threshold modelling (see Baum, Checherita-Westphal, and Rother 2012). While their interest rate results, particularly the coefficient magnitudes, are similar to those reported here, their focus on Eurozone economies is not adequately justified. Rather, it is merely suggested that ‘the EMU offers economic dynamics that are rarely found elsewhere in the world’ and ‘averaging across the OECD makes policy inferences difficult’ (Baum, Checherita-Westphal, and Rother 2012, 4). The paper largely has an econometric focus, rather than providing a good exposition of recent trends in Eurozone public debt, growth and interest rates, and linking these to the underlying institutional arrangements.

15. Eurozone economies include Portugal, Ireland, Italy, Greece, Spain, France, Austria, Belgium, Finland, Germany, Luxembourg and Netherlands. Data available from OECD (2012b). TSLS and GMM estimations are performed using Eviews 7.

16. Variable selection is largely based on Checherita and Rother (2010). A 3-year cumulative overlapping growth rate is also used but is statistically insignificant.

17. Debt service is the ratio of general government net debt interest payments to general government total tax and non-tax receipts (see OECD 2009). Bernoth, von Hagen, and Schuknecht (2004) argue that debt service has become an important fiscal indicator since the creation of the EMU. These authors and OECD (2009) report empirical work that finds a non-linear relationship between debt service and long-term interest rates. Here, we also investigate a non-linear relationship between debt service and economic growth.

18. ‘A nominal effective exchange rate is the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in either the country’s international trade or payments’ (OECD 2011b). Pope and Selten (2012) note that exchange rates have been omitted from a number of tipping point investigations.

19. A definition is available from OECD (2011b). The variable is constructed so a deficit is positive.

20. A balanced panel of sovereign economies is also investigated, including; Australia, US, UK, Japan, Canada and New Zealand. TSLS and GMM regressions, and threshold modelling did not reveal any significant linear or non-linear relationships between gross debt to GDP, debt service to GDP, long-term interest rates and economic growth among sovereign economies over the sample period (1998–2011). For brevity, these results are not reported.

21. These results are reported to convey the relative ease of identifying simple correlations between debt variables and economic growth, and to largely reproduce Checherita and Rother’s (2010) findings.

22. Instruments are time-lags on all regressors. Instrument lag selection is based on the Sargan statistic for valid over-identifying restrictions.

23. For brevity, these results are not reported but are available from the author upon request.

24. Eviews code for panel unit root tests and threshold effects are available from Galimberti and Cupertino (2009). Results are available from the author upon request.