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Bond MarketIMF WEO Debt Reduction Chapter

IMF WEO Debt Reduction Chapter

The International Monetary Fund (IMF) has recently published its World Economic Outlook (WEO) which has a combination of a report and an annual database of macroeconomic data (including forecasts). The beauty of this database is that the IMF has boffins that work to harmonise the data across countries. I normally do not pay too much attention to the text of the report, but it has a chapter entitled “Coming Down to Earth: How to Tackle Soaring Public Debt” which attracted some attention. (There was also a chapter on the natural rate of interest that would probably cause me to lose a portion of what remains of my hair.)

I am not going to get into the discussion of whether we are supposed to worry about the debt/GDP ratio, but I would note that the discussion is global — with quite a bit of it aimed at debt restructuring in poorer countries. That is outside my area of experience, so I am staying clear of that. Instead, I just want to make some quick comments about the floating currency sovereign parts. Even though I do not care about the debt/GDP ratio, some people do — and they often impose austerity policies to deal with them.

Methodology Leaves Me Cold

I have always done my best to ignore econometrics on the theory that I am a mathematician and not a statistician. I am sure the people who worked on the report know far more about econometrics than I do, and could respond to my worries with a wall of jargon. That said, I am not happy with parts of the methodology. My concern is the analysis is showing generic changes to debt-to-GDP ratios.

The root of the problem is that debt is a stock, and GDP is a flow. I am not offended by the existence of the debt/GDP on that grounds, rather my argument is that fiscal retrenchment is a flow change that is standardly assumed to have an effect on flows. That is, if we attempt to cut the deficit by 1% of GDP (assuming nothing changes), there is presumably some reduction of GDP growth (relative to the no-cut baseline), with the reduction determined by the ever-elusive fiscal multiplier. (E.g., if the multiplier is 0.5, GDP will drop by 0.5%.) This reduction in growth would then have an impact on other fiscal variables.

If we want to analyse the effects of fiscal retrenchment, that is where we have to stick. The effect on the debt-to-GDP ratio will then be mechanically determined by the fiscal deficit (change in debt) and the new level of nominal GDP.

To see the problem, imagine that nominal GDP jumps by 1% (the country wins the lottery or something). If the debt/GDP ratio was 50%, the new ratio is 49.5% — a 0.5% drop. If the debt/GDP ratio was 100%, the same 1% jump cuts the debt/GDP ratio to about 99% — a (roughly) 1% drop.

Of course, national economies do not win lotteries. But debt trajectories behave quite differently based on the relationship between nominal growth levels and the starting level of debt/GDP.

Primary Versus (Total) Deficits

One of my theoretical beefs with mainstream fiscal analysis is the use of the primary deficit (the fiscal deficit less interest expenditures). The idea is that in standard simple macro models, the government consumes real goods (“G”). So fiscal policy is specified in terms of how much real goods are consumed (and tax (“T”)).

The problem is that the government also does a lot of transfers, and those transfers are conditional on the state of the economy. Excluding interest spending from the deficit analytically implies that interest spending has a multiplier of zero. Although I accept that the multiplier is not very high, it is certainly not going to be zero. (Otherwise, the government could pay 100% of GDP in interest payments, and have no effect on growth — which is implausible.)

National Experience Correlated

The problem with doing statistical exercises across “consolidation exercises” in the developing country is that countries’ experiences are correlated. In addition to there being a global business cycle, there are macroeconomic fads that sweep across countries.

Presumably, one could get excited by the details of the policy implementation (e.g., tax increase versus spending cut, which I think is a big part of the pro-austerity literature), but it is rather awkward to pretend that the micro-details of fiscal policy are the primary driver of growth, as opposed to the private sector business cycle.

Canadian Consolidation

The chart above shows the drops in gross/net general government debt in Canada since 1990 (from Statscan). I just ran this chart in an earlier article, and so will not discuss it too much. The focus here is the drop in the debt levels after the mid-1990s. (Gross debt started to drift away from net debt courtesy of changes to the pension system.)

Note that I am showing “general government” and not the Federal Government. The reason is straightforward: the provinces have a large economic footprint. The feds transfer money to the provinces, and so we could have things like the Federal government cutting its spending and debt by cutting transfers, and pushing the debt increases to the provinces. (I have not chased after the data, but I believe that Federal austerity was eased by the fact that it pushed the hard decisions to the provincial/municipal levels.)

Anyway, we can ask — how did the debt/GDP ratio fall? The IMF data tells us.

The top panel shows the General Government deficit (technically, net lending). It was quite large in the 1980s and the early 1990s recession — around 8% of GDP. However, it then headed towards a surplus by the end of the decade. This was mainly achieved by shrinking government, but it was also helped by some unsustainable practices (cutting capital expenditures, which then forced emergency spending after the 2010s when overpasses started to collapse).

Despite the fiscal retrenchment, nominal GDP growth continued. If a country can achieve a balanced budget and nominal GDP is still growing at 5%, the debt/GDP ratio is going to plummet (until it drops to a low level).

“Huzzah!” cheer the neoliberals — all we need to do is do whatever Canadian governments did in the 1990s! (Note that Canada was not the only country with such performance, but it is a somewhat cleaner analytical case than countries that benefited from euro convergence.) The problem with that story is nominal growth was strong because the private sector was booming in the 1990s. As was discovered in the 2010s, if the private sector is not able to take on a lot of new debt, fiscal retrenchment can result in very low nominal GDP growth — which plays havoc on the debt/GDP ratio.

Concluding Remarks

For a floating currency sovereign, the debt/GDP ratio has very little economic significance. But if your job requires you to worry about it (e.g., your bosses do not know what they are doing), it is largely going to be driven by nominal GDP growth. That in turn is going to rely on the state of animal spirits in the private sector.

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(c) Brian Romanchuk 2023


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