Learning lessons from internal budgetary models

Dan O'Brien

Economics Editor

ANALYSIS : WHAT IS a sustainable level of public (and private) debt? Even now, after years of financial crisis and an ongoing, wholesale revaluation of the functioning of the financial system, the answer is not at all clear.

Relative to the size of its economy, Japan has the largest public debt in the world – larger even than Greece’s. Despite such massive debt – almost 200 per cent of GDP – and two decades of sluggish economic growth, people are prepared to lend to the Japanese government at super-low rates of interest.

Contrast this with Spain, where public debt, at just 60 per cent of GDP, is lower than in Germany. Despite this, investors seek a large premium to lend to the Spanish government. At times over the past six months, Spain has looked to be on the verge of being locked out of the bond market.

(The same issue of sustainability could be asked about household debt levels. While it is commonplace to hear the view that Irish household debts are too high and some borrowings will have to be written off, households in Denmark and the Netherlands among peer countries are even more indebted, yet there is far less talk in either country about household indebtedness.)

Given all the above, and countless other examples, it seems clear there is no level of debt beyond which objective criteria say is unsustainable. And because any evaluation of what is sustainable is subjective, confidence is crucial.

Confidence has been gravely undermined in the periphery of the euro zone, affecting the entire bloc. Markets have increasingly come to the view that, in much of the periphery, public debt is at or beyond sustainable levels.

Restoring confidence (if it can be achieved) will be a long and multifaceted endeavour. Credible commitments to fiscal discipline will be one – and only one – facet.

Economically and financially, credible new fiscal frameworks at national and euro zone level are arguably the least urgent part of the crisis resolution package, but they are being given precedence. The finalisation of a fiscal treaty/compact among 26 EU countries is expected this weekend. That is happening for political reasons – the northern creditor countries insist on it to reduce the likelihood of further bailouts and to deal with the long-term moral hazard created by bailing out the weaker economies.

In the debate there has been surprisingly little discussion of the relevance of internal budgetary rules in member states and, in particular, the rules between central governments and sub-national levels of government (regions and municipalities).

This has always been a major issue in de jure federations, such as Austria and Germany. In recent decades, it has become more important in most unitary states as sub-national levels of government do more of the spending and, if to a lesser extent, more of the tax-raising.

This trend has been most marked in Spain, where central government accounts for a smaller share of total public spending than in Germany. (Ireland, incidentally, is an extreme outlier in the amount of tax raised and money spent by sub-national levels of government).

“Stability pacts” among the different levels of governments within countries have worked far better than among the euro area countries collectively, where the Stability and Growth Pact underpinning the single currency project failed so obviously. With the recent exception of Madrid bailing out Valencia’s regional government, central governments in Europe have not had to rescue regional governments.

Although national stability pacts differ greatly in the extent of surveillance, sanctions for breach of rules and limits to spending, taxing and budget deficits for sub-national levels of government, it seems to me that the most obvious reason internal bailouts have been avoided is because sub-national governments tend to have low debt levels. In Europe, central/federal governments account for most public debt.

The picture is broadly similar in the US. There, 49 of the 50 states have debt brakes in their constitutions. If revenues fall, states are obliged to introduce budget-balancing measures, which often include large-scale lay-offs and have even led to full shutdowns of state government when cash runs out. The federal government does not formally bail the states out, but funds from Washington flow to the states to mitigate the contraction in private and state government demand.

One result of this is that the US states have low levels of debt, while the federal government has gone deeper into the red. This system has worked, at least in the sense that no state government has defaulted since the Great Depression in the 1930s.

As it stands, in the euro zone, there are almost no central government transfers (ie from “Brussels”) to alleviate the effects of balancing the national books, and none of the public debt is pooled. If this situation proves to be sustainable, it will be a unique case.

Another aspect of internal stability pact arrangements is trust in the honesty and competence of different levels of government in each other and a broadly similar commitment to fiscal rectitude.

The latter is entirely absent in the euro zone. Examples abound, but differences between France and Germany – countries which are so often mistakenly considered to be at one on dealing with the crisis – are just one case. From the turn of the century, successive German governments cut inflation-adjusted public spending year after year in an effort to pay down the accumulation of debt run up following reunification in the early 1990s. This was not only supported by the German electorate, it was popular too.

In France, where the budget has been in deficit every year since the 1970s, talk of curtailing public spending is met with sharp opposition and often street protests.

If voters’ attitudes towards fiscal management differ across the euro zone, the confidence of national elites in one another is at an unprecedented low. The manner in which Greek governments accumulated and then hid public debt has destroyed a great deal of the trust that existed among euro zone countries.

Backsliding on reform commitments since being bailed out has further eroded that trust, as did the promise-breaking last summer of Silvio Berlusconi, the former Italian prime minister, after the ECB began buying Italian government bonds. Rebuilding trust will be a herculean task.

The recent lull in the euro area crisis is a very welcome respite. But with such enormous challenges to be addressed in putting the currency union on a stable foundation, don’t expect it to last.

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