A decade after the beginning of the Global Crisis, the governments of most advanced economies are drowning in debt. According to the IMF, the government debt-to-GDP ratio for the major advanced economies that comprise the G7 rose from 82% in 2007 to 120% in 2016 (IMF 2017).1 In the aftermath of the Global Crisis, the fiscal challenge overburdened central banks, already tasked with restoring financial stability and economic growth. The response has been impressive – unprecedented balance sheet expansions and exceptionally low policy rates. However, the results have been uneven in allaying fears regarding debt sustainability. While central banks have been very effective in diffusing fiscal concerns for some countries, for other countries central banks may have contributed to the concerns. Monetary policy and fiscal dynamics are inexorably linked. Have monetary policy actions since the crisis become a more important driver for debt dynamics than fiscal policy actions?
Comparing Germany, Italy, and Japan is illustrative.2 Figure 1 plots the debt-to-GDP ratio for the three countries from 1998 to 2016.
Figure 1 Government debt
As can be seen, Japan’s debt ratio has been rising sharply both before and since the crisis. Italy’s debt ratio was on a slowly declining path before the crisis but has been rising since 2007. Germany’s debt ratio rose after 2007 but has been declining since 2012. Judging from the trajectory of debt, and the fact that its current debt ratio exceeds 240% of GDP, one might have expected Japan’s debt to be considered risky. And yet, according to financial market indicators, Italy, with a debt ratio under 140 percent of GDP is considered to be the greater risk. Credit default swaps (CDS) spreads on government debt are indicative of market-based assessments. During the first four months of 2017, the five-year CDS spreads for Japan, Germany, and Italy averaged 25, 20, and 175 basis points, respectively. The low CDS spread on German debt is unsurprising. Comparing the CDS of Japan and Italy suggests a puzzle. Japanese government debt is considered to be nearly as safe as Germany’s. In contrast, Italy’s debt, is seen as considerably riskier and out of line with what would be expected of a major advanced economy. Do these CDS spreads reflect Japanese government frugality and Italian fiscal profligacy?
Hardly. A direct comparison of fiscal policy reinforces the apparent puzzle. A critical summary indicator of fiscal policy is the primary fiscal balance – the difference between general government revenues and expenditures. Figure 2 plots the primary fiscal balance as a ratio of GDP for the three countries – negative values indicate deficits and positive values indicate surpluses. As can be seen, Italy’s fiscal stance has been considerably more restrained than Japan’s and has even been slightly more restrained than Germany’s. This suggests one should look beyond fiscal policy to identify the likely culprits of the perceived riskiness of Italy’s debt relative to the perceived safety of Japan’s debt.
Figure 2 Government primary balance
To identify the culprits, it is useful to recall the basic determinants of debt dynamics and the crucial interaction between real factors and monetary policy. Consider a government with a positive level of debt. The crucial question in determining fiscal sustainability is not the absolute size of the debt, but whether the ratio of the country’s government debt to GDP can be expected to consistently decline in the foreseeable future. As with any ratio, the key is to compare the rate of growth of the numerator (debt) and the denominator (GDP). If the government maintains primary balance, the total deficit, which determines the growth rate of the debt, will reflect the cost of refinancing the debt.3 To maintain sustainability, the nominal interest rate must be lower than the nominal growth of GDP; that is, the interest-rate-growth differential must be negative. Indeed, when the interest rate is consistently low or GDP growth is consistently high, debt is sustainable and the debt-to-GDP ratio is declining even if the government maintains small primary deficits. The interest-rate-growth differential creates a snowball effect on debt dynamics. When legacy debt is high, as was the case before the crisis, the snowball effect can be far more important than fiscal policy for debt dynamics.
Monetary factors as well as non-monetary factors are important in determining whether the snowball effect will help improve or lead to a deterioration of debt dynamics. For example, growth-friendly structural reforms that raise the growth rate of potential output is a critical non-monetary factor.
Some central bank policies can unnecessarily worsen debt dynamics. In the recessionary environment that followed the Global Crisis, countries where monetary policy was insufficiently accommodative experienced persistently low inflation and depressed growth. Persistently tight monetary policy can create a major debt problem for a government even if primary deficits are kept low. In addition, for any given level of risk-free interest rates, central banks can create major fiscal problems if they pursue policies that raise the perceived risk characteristics and thus the cost of refinancing government debt. For example, policies that induce fear that a government might be forced to default on its debt obligations in the future raise the risk premium that investors demand as compensation for such fears. Such policies raise the interest rate a government faces to refinance its debt and can render the debt unsustainable even if the government is running primary surpluses. Fears of default can be self-fulfilling. Central bank policies can be crucial for avoiding this fragility, an issue that proved particularly important in the Eurozone during the crisis (De Grauwe 2011, De Grauwe and Ji 2012).
Conversely, central banks can take measures that improve fiscal tensions. In theory, a central bank can wipe out the real value of a country’s debt through high inflation. However, the undesirable consequences of this approach are well known and in practice policies leading to high inflation would be inconsistent with the price stability mandate of all major advanced economies’ central banks.
Another policy option is financial repression. The central bank can induce conditions that reduce the real cost of financing government debt.4 Within limits, financial repression can reduce the risks associated with high debt without compromising price stability.
Financial repression is a key feature of quantitative easing (QE) policies. The outright purchase of long-term government debt reduces the supply of government debt available in the private sector which in turn reduces long-term term premia and eases the fiscal burden on government debt. Appropriately implemented, QE not only can defend against deflation and restore economic growth, but can also dispel debt sustainability concerns.
Figures 3 and 4 compare the nominal GDP growth rate and the annual average long-term government bond yields for Germany, Italy and Japan. The comparison provides information for the components of the snowball effect on debt dynamics in the three countries.
Figure 3 Nominal GDP growth
Figure 4 Long-term government bond yields
For Japan, the dramatic rise of the debt ratio before the crisis reflects the lack of nominal growth. While the long-term government bond yield appeared to be low (consistently below 2%), nominal GDP growth was even lower (about zero, on average). The adverse debt dynamics worsened after 2007, with the recession following the Global Crisis. Part of the problem was overly tight monetary policy: policy rates were constrained by the zero lower bound (ZLB), but the Bank of Japan was reluctant to employ the required QE policies. However, since 2013 the Bank of Japan has embarked on a decisive QE programme which has simultaneously boosted nominal GDP growth and depressed long-term government bond yields. Since September 2016, as part of its ‘Quantitative and Qualitative Monetary Easing with Yield Curve Control’ policy, the Bank of Japan has communicated explicitly its intention to keep the 10-year yield on government bonds close to zero and short-term interest rates negative until inflation rises to 2%, in line with its definition of price stability. This monetary policy has stabilised Japan’s debt dynamics and has provided the Japanese government more time to implement structural reform measures and complete the fiscal adjustment needed to bring its primary deficit under control.
In contrast to Japan, where in the past few years decisive monetary policy actions have allayed fiscal concerns, in Italy monetary policy decisions appear to have contributed to debt sustainability concerns. Italy shares its central bank, the ECB, with other Eurozone member states, including Germany. The ECB is obligated to implement a single monetary policy for the benefit of the Eurozone as a whole. However, since the crisis, the ECB has adopted policies with decidedly uneven economic consequences for Eurozone member states. Italian nominal GDP growth has been consistently and significantly below Germany’s, while the long-term yield on Italian government debt has been consistently and significantly above Germany’s. While some of the difference can be attributed to non-monetary factors, discretionary ECB decisions have played a critical role. Among others, the single monetary policy in the Eurozone has been implemented in a manner that has tended to reinforce tighter monetary conditions in Italy than in Germany, contributing to a deep and prolonged recession in Italy while facilitating faster growth in Germany.
Monetary policy and fiscal dynamics are inexorably linked. Without compromising price stability, central banks in advanced countries have the power to pursue policies that can allay debt sustainability concerns. Comparing Japan and Italy, against the backdrop of Germany, is instructive for understanding this power and its consequences.