Speakers of the session
Colin EllisMoody's Investors Service, Chief Credit Officer, EMEA
Per CallesenDanmarks Nationalbank, Governor
Stephanie PamiesEuropean Commission, Head of Sector, Sustainability of Public Debt, DG for Economic and Financial Affairs
Mahmood PradhanInternational Monetary Fund, Deputy Director, European Department
Rolf StrauchEuropean Stability Mechanism, Chief Economist, Management Board Member
Andreas DombretDeutsche Bundesbank, Former Member of the Executive Board
Objectives of the sessionHigh levels of public indebtedness were a key driver of the EU sovereign debt crisis and one reason why the recovery of the real economy has been so slow. This sovereign debt crisis has highlighted the importance of reducing public debt levels and building up sufficient buffers during normal and good times.
The objectives of this session are to discuss the issues related to sovereign debt sustainability in EU countries, the potential impact of changes in interest rates and the possible improvements in the EU fiscal framework, which could ensure fiscal discipline in all parts of the euro area.
Points of discussionAre some EU countries at risk of falling into debt traps and being notably vulnerable to an increase of interest rates?
How can Europe encourage more rigorous discipline in all parts of the euro area and the EU? Do we need debt restructuring processes in some EU countries?
Background of the session
Public debt vulnerabilities remain high in a small set of-mainly large- European economiesAt an aggregate level, EU public finances compare positively to other advanced economies. The euro area government debt ratio has been decreasing since 2014 and reached less than 87% of GDP in 2018. At the same time, some other advanced economies exhibit much higher ratios (around 238% of GDP in Japan and around 106% of GDP in the United-States).
Fiscal positions of EU countries have improved visibly since 2016. All Member States, except Spain, have exited the Excessive Deficit Procedure (EDP), compared to 24 Members in EDP 2011.
But challenges remain in the European Union. The public debt is high in the euro zone excluding Germany. Fiscal risks are essentially concentrated on a small set of - mainly large - European economies. If most EU Member States have successfully managed to reduce their debt ratio over the last few years (notably in Austria, Netherlands and Finland), other countries – such as Italy, France, Spain and Belgium – are still faced with increasing or not sufficiently receding government debt ratios. Although Italian debt is significantly higher than that of France (130% versus 100% of GDP in 2018), unlike Italy, France has had a primary budget deficit for several years and its debt is mainly held by non-residents.
In addition, even though these expansive fiscal policies were put in place a long time ago in these highly indebted countries, they failed to increase their potential growth because they did not carry out sufficient structural reforms (of the labour market, the education system, support for innovative companies, etc.).
As long as we do not understand notably in indebted countries (France, Italy, Spain etc) that excessive debt is a source of under competitiveness, the economic situation will continue to deteriorate in these countries. Only domestic structural reforms can resolve structural issues and increase productivity and growth. It is an illusion to try to solve the structural problems of our economies by a prolonged increase in public or private debt. Yet this is what we have tried to do by pursuing lax fiscal, monetary and political policies that pose systemic risks to financial stability and therefore to future growth.
France and Italy notably are suffering from a supply problem, due to the decline in industrial production capacity, the deterioration in cost competitiveness, the low level of labour force skills and the low level of potential growth, especially in Italy. When demand increases in France and Italy, this increase in demand mainly leads to an increase in imports and not in domestic production. Increasing fiscal deficits in these countries could only lead to a noticeable rise in interest rates that may threaten fiscal solvency and dampen private sector demand.
In such a context, France urgently needs to rebalance its public accounts in order to reduce the excessive level of tax and contributions which are detrimental to the competitiveness of French companies. What is needed is a reduction of public expenses, which represented in 2018 56% of GDP compared to 41% in Spain or 43% in Germany and not a lesser increase.
Italy, for its part, needs to increase its potential output and reduce public debt, which represents a major potential source of financial spill over for the rest of the euro area. No illusions should be held over the capacity to stimulate demand in these highly indebted euro-zone countries.
The economic consequences of high government debtWe cannot see any positive outcome of the situation of high public debt in certain EU countries, notably considering the budgetary costs of population ageing (pensions, healthcare). For the public finances, higher rates increase the cost of the debt and make it more difficult to reduce the debt-to-GDP ratio. Higher long-term interest rates and a re-pricing of sovereign risk may reignite government debt sustainability concerns in the absence of further reforms and consolidation efforts.
In its Economic Bulletin (Issue 3/2016), the ECB explains the significant economic challenges raised by high government debt.
First a high government debt burden makes the economy more vulnerable to macro-economic shocks and limits the room for counter-cyclical fiscal policy. For instance, a rise in long-term interest rates may reignite pressures on more vulnerable sovereigns, thereby triggering a sovereign risk re-pricing.
Second a high government debt entails the need to sustain high primary surpluses over long periods, which may be difficult under fragile political or economic circumstances. Indeed, high primary surpluses are difficult to maintain under adverse economic conditions.
Third theoretical and empirical literature suggests that high government debt burdens can ultimately impede long-term growth. This is particularly the case when it is contracted to finance unproductive expenses. While country heterogeneity plays an important role, several studies reveal that detrimental growth effects may appear at levels of around 80-100% of GDP.
The debt rule in the EU fiscal framework has effectively not been implemented since the start of the EMUAll 28 EU member states are committed by the paragraphs in the EU Treaty, referred to as the Stability and Growth Pact (SGP), to implement a fiscal policy aiming for the country to stay within the limits on government deficit (3% of GDP) and debt (60% of GDP); and in case of having a debt level above 60% it should each year have a declining trend.
However, the Stability and Growth Pact regarding debt criteria has effectively not been implemented since the start of the EMU. In 2007, a number of countries recorded government debts to GDP ratios. Despite the different reforms which took place after the sovereign debt crisis, the public debt ratio in significant European Union countries continues to increase and is approaching 100% of GDP or even more in certain Member States.
Looking ahead, it should be ensured that compliance with the requirements of the debt reduction benchmark is not unduly delayed. This requires complementary policy action. A monetary union is not workable without economic convergence and fiscal discipline. The enforcement of the Stability and Growth Pact has been too lenient since 2003. EU Fiscal rules need to be enforced more rigorously and should be more binding and effective. By converging towards lower levels of government debt and regaining fiscal buffers, the euro area will increase its resilience and fiscal space to cope with potentially adverse economic shocks in the future.