Friday, February 3, 2012

Repaying the Debt?

A lot of attention recently has been given to the fiscal rules that formed the basis of the recent EU treaty (inter-governmental agreement?).  One that has attracted significant attention is the Debt Brake or “One-Twentieth Rule”.  The balanced budget rule allowed a structural deficit is no more than 0.5% of GDP is probably more important but some of the commentary on the Debt Brake is worth considering.

On last night’s Primetime, Miriam O’Callaghan introduced a question to Kieran O’Donnell by saying:

“People are talking about €6 billion needed to take out on an annual basis”

On the previous night’s Vincent Browne, Stephen Donnelly said:

“To pay down €100 billion in five years you’ve got to pay down €5 billion a year, that’s what the treaty says.”

I have read the treaty and I don’t know where this is coming from.  The opening report on Primetime suggested that if our debt peaks at 118% of GDP in 2013 we would then have 20 years to reduce the debt and that we would have to “dramatically pay down this debt”.  The prospect of repaying debt is not an attractive one given the current state of the Irish economy.  However, it is not a prospect we are are not likely to face.

Ireland is currently in an Excessive Deficit Procedure which is largely about getting the annual fiscal deficit below 3% of GDP.  For 2012, we are targeting a deficit of 8.6% of GDP, and the current plan is to get that down to 2.9% of GDP by 2015.  As long as a country is in the EDP it is that annual deficit rather than the total debt that is key metric. 

And then once the country gets the deficit below 3% of GDP it enters a three-year transition period before the debt rule becomes effective.  This was explained in this Council Regulation:

"For a Member State that is subject to an excessive deficit procedure on 8 November 2011 and for a period of three years from the correction of the excessive deficit, the requirement under the debt criterion shall be considered fulfilled if the Member State concerned makes sufficient progress towards compliance as assessed in the opinion adopted by the Council on its stability or convergence programme. "

The implications for each country are more clearly detailed in this press release.  The last line confirms that Ireland will not be subject to the "numerical debt reduction benchmark", the one-twentieth rule, until 2018.  This is likely to be the earliest.  The three-year transition period does not begin until the excessive deficit has been corrected.  In this three-year period a country has to show is “sufficient progress towards compliance”, which is rather woolly.

It is also important to note that the “one-twentieth” rule does mean the debt has to reach the 60% of GDP target in 20 years.  It specifies that about one-twentieth of the gap between the current debt level and the 60% of GDP target must be closed each year.

Under the rule a country with a debt of 120% of GDP has 20 years to get the debt down to 70% of GDP, with the one-twentieth improvement getting so small that it can take another 20 years to bring the debt down to the 60% of GDP level.

Debt Brake

The required reductions in the debt ratio appear large at first but do moderate significantly as the debt converges on the 60% level.  This is not a linear projection that will require €x billion to repaid each year.

Given our deficit problems, the focus until 2015 and beyond will be on bringing down the deficit rather than repaying debt.  There is no requirement to repay debt and bringing down the deficit will stabilise and, in time, reduce the debt ratio.

So what happens in 2018?  Will we have to start “taking out” money from then?  Debt projections out to 2018 are unlikely to be very reliable.  In its last published review the IMF projected a General Government Debt of 111% of GDP in 2016.  With the planned reduction in the deficit that could be down to 105% of GDP in 2018.  No one can be sure.

If the debt brake is applied for a country with a debt of 105% of GDP they would have to reduce the debt ratio to 101% of GDP the following year. [Technically they only have to budget to achieve the required debt reduction rather than actually achieve it.]

A country with a balanced budget would achieve that with a real growth rate of 2% and an inflation rate of 2%.  There would be no necessity to make any debt repayments.

In fact, once the debt ratio gets below 90% of GDP, a country with 2% inflation and growth rates would be able to run (small) deficits and still meet the debt reduction requirements.  The debt brake does not eliminate the potential to borrow additional money but it does substantially limit the rate at which this money can be borrowed.

From an Irish perspective (and the perspective off all other countries) the balanced budget rule  is far more significant.  This requires a structural deficit of no more than 0.5% of GDP (1.0% of GDP for countries with a debt of below 60% of GDP).  If by 2018 Ireland has a structural deficit of less than 0.5% of GDP it is likely that we would satisfy the conditions of the “one-twentieth” debt brake rule without the need for any additional measures.

If the budget has been brought into balance by 2018 (a big if but we have the luxury here of just having to assume it) it is likely that growth and inflation would do most of the heavy lifting for the debt ratio reduction.  With a balanced budget an inflation rate of 2% and a growth rate of 2% would be enough to bring the debt ratio down from 105% of GDP to 101% of GDP and all the way down to the 60% target.  We would not have to make any debt repayments but could choose to do so.

As stated above it is the balanced budget rule which will potentially have a greater effect .  The conditions and effect of the debt brake are fairly objective and clear.  There is no consensus on how a structural deficit should be measured so the precise implications of the balanced budget rule cannot be objectively assessed.  The 3% limit on the overall budget deficit remains.

6 comments:

  1. Hi Seamus,
    Thanks for this, incisive as always. I saw Stephen Donnelly talking about this, while I was not fully aware of the finer details, I couldn’t believe he was so na├»ve to think we had 20 years to get rid of €100 billion worth of debt and that we would need to grow by 7-8%. No wonder he thought it was a bad deal. To be fair the Treaty text is a slow read. The press release you referenced was much clearer. A couple of points though:

    “Under the rule a country with a debt of 120% of GDP has 20 years to get the debt down to 70% of GDP”

    Should this be 20 years to get the debt down to around 80% (81.5%), according to my calculations anyway?

    “If the debt brake is applied for a country with a debt of 105% of GDP they would have to reduce the debt ratio to 101% of GDP the following year”

    Should this be 102.75% of GDP the following year? (105 - 60)*.05 = 2.25 105-2.25 =102.75?

    Thanks.

    ReplyDelete
    Replies
    1. Hi Patrick,

      Although it is called the "one-twentieth" rule the actual formula is a not just a simple calculation. See slide 10 of a recent presentation by Philip Lane. Note that all the debt levels on the right hand side should be bt-1 as the bt-2 is a typo. A "one-twentieth" rule approximates this.

      Delete
  2. Seamus
    "If the debt brake is applied for a country with a debt of 105% of GDP they would have to reduce the debt ratio to 101% of GDP the following year"

    I say the Kieran O'Donnell/Miriam O'Callaghan interview and not knowing the figures was astounded that such large reductions were 'required'.
    Thank you for setting that straight and pointing out that it is not a straight line reduction. Can you confirm that the reduction is recalculated each year to get the sloped curve above?

    I have looked at Philip Lane's formula and not being a mathematician, I looked away again. I will get some assistance over the weekend hopefully.

    On a simple understanding of the reduction should year one approximate 1/20 of required reduction.
    In your above example that would be 1/20 of (105-60)=1/20 of 45=2.25%, bringing deficit from 105 to 102.75%? A reduction to 101%, a full 4% reduction sounds high in year one.
    Would it be possible for yourself (or indeed Philip Lane) to worked out the required yearly reduction starting from a base of say 105%.

    One further question. Who will calculate the structural deficit and present the differences between the actual deficit and structural deficit?

    ReplyDelete
  3. Hi Joseph,

    The only variable that goes into calculating the debt target for any year is the debt ratio in the previous year so in this sense it is recalculated every year. The target lasts for one year and is redone. It is not a case of starting at a certain debt ratio and having to get to the level implied by the rule say ten years in advance of that. The target is an annual one.

    And remember it is only sufficient that a country budget to try and achieve the target using independent forecasts. If there are some factors that we unknown at the time of the budget that cause the country to miss the target they just move on to the newly calculated target for the next year. There is no penalties for things that can't be foreseen. As long as the numbers in the Budget stack up (and it will no longer be able to use Department of Finance forecasts) then the debt rule is satisfied.

    The simple 1/20th rule would be a slow way of bringing the debt down to 60%. The actual rule is slightly faster. You can see a comparison of both for a country with a 120% of GDP debt ratio in this spreadsheet. There are also the required debt dynamics for 105%, 90%, 75% and 60% debt levels though they can be largely inferred from the 120% column.

    And again if a country has a debt ratio of 105% of GDP it is not the case that it has, for example, 15 years to being the debt ratio down to 70% of GDP. These are just indicative columns showing what might happen. The actual debt targets are recalculated every year. If a country under-achieves one year it does not have to make good the shortfall in subsequent years but must hit a revised target. If a country over-achieves it cannot carry forward the excess but must hit a lower target the next year. The rule only looks forward one year so again only treat this calculations as indicative.

    ReplyDelete
  4. I think what people worry about is the scenario where there is no growth no inflation, then the debt does have to be paid down, and not just magic-ed away by increase in gdp.

    Although it is realistic to expect gdp to increase by 4% p.a. from looking at long term patterns in inflation and growth of countries.

    ReplyDelete
    Replies
    1. Yes, that is a fear alright but it will be 2018 before we will be subject to this rule. There is a lot that can happen between now and then. It's the start of February and we don't even know what 2011 growth was yet, never mind what will be happening in six years.

      Delete

Printfriendly