Can large primary surpluses solve Europe’s debt problem?

Barry Eichengreen, Ugo Panizza

For the debts of European countries to be sustainable, their governments will have to run large primary budget surpluses. But there are both political and economic reasons to question whether this is possible. The evidence presented in this column is not optimistic about Europe’s crisis countries. Whereas large primary surpluses for extended periods of time did occur in the past, they were always associated with exceptional circumstances.

Europe’s economies have heavy debts and gloomy growth prospects. This fact raises obvious concerns about the sustainability of public debts, concerns that have manifested themselves periodically in increases in the yields that investors demand to hold governments’ debt securities. As we write, investors are relatively sanguine. The question is whether they will remain so. It is whether – and if so, when – worries about debt sustainability will be back.

The IMF, in its Fiscal Monitor (2013), sketches a scenario in which the obligations of heavily indebted European sovereigns first stabilise, and then fall to the 60% level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables, and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. The heavier the debt, the higher the interest rate and the slower the growth rate, the larger the requisite surplus. The average primary surplus in the decade 2020-2030 is calculated as 5.6% for Ireland, 6.6% for Italy, 5.9% for Portugal, 4.0% for Spain, and 7.2% for Greece.

These are large primary surpluses. There are both political and economic reasons for questioning whether they are plausible. When tax revenues rise, legislators and their constituents apply pressure to spend them. In 2014, Greece enjoyed its first primary surpluses after years of deficits and fiscal austerity; the government immediately came under pressure to disburse a ‘social dividend’ of €525 million to 500,000 low-income households. Budgeting, as is well known, creates a common pool problem, and the larger the surplus, the deeper and more tempting is the pool. Only countries with strong political and budgetary institutions may be able to mitigate this problem (de Haan et al. 2013).

Turning to the economics, a slowdown in global growth, worsening terms of trade, and a recession can all disrupt the efforts of even the most dedicated governments seeking to run large primary surpluses for a decade. Recession depresses tax revenues, and the spending cuts needed to maintain the surplus above the promised threshold may depress activity and revenues still further. The government may prefer to let its automatic fiscal stabilisers operate. Whatever the other merits of that choice, it too will prevent the string of primary surpluses from being maintained.

These are high hurdles. Researchers at the Kiel Institute (2014) conclude that “assessment of historical developments in numerous countries leads to the conclusion that it is extremely difficult for a country to prevent its debt from increasing when the necessary primary surplus ratio reaches a critical level of more than 5%”.

Large and sustained primary surplus episodes

In recent work (Eichengreen and Panizza 2014), we explore whether the expectations that European countries will be able to run such large surplus are realistic. We use a sample of 54 emerging and advanced economies over the period 1974-2013 to study what type of economic and political variables are associated with large and persistent primary surpluses.

In this sample there are 36 such episodes (about 15% of the 235 5-year periods included in our sample) of primary surpluses of at least 3% of GDP that last for at least five years. Larger and longer primary surplus episodes are rarer. Primary surpluses as large as 4% of GDP that last for at least a decade are extremely rare (see Figure 1).

Figure 1. Five-, eight-, and ten-year episodes of primary surpluses as percentages of GDP

We use a probit model to analyse which political and economic variables are correlated with long and persistent primary surpluses. Looking at surplus episodes that average at least 3% of GDP and last for 5 years, our estimates for advanced economies suggest that a one percentage point increase in domestic growth is associated with a 12 percentage point increase in the likelihood of a large and persistent primary surplus. A ten percentage point increase in the debt-to-GDP ratio is associated with a 2 percentage point increase in the likelihood of a large and persistent primary surplus episode.

Focusing on political variables, we find that surplus episodes are more likely when the governing party controls all houses of parliament or congress (its bargaining position is strong) and in countries with proportional representation (which can give rise to encompassing coalitions). We also find that left-wing governments are more likely to run large and persistent primary surpluses.

Episodes that are greater than 3% and that last longer than eight years are economically and politically idiosyncratic in the sense that their incidence is not explicable by the economic and political correlates included in our regressions. Therefore, we provide a close examination of the five countries that were able to maintain a primary surplus of at least 4% of GDP for at least ten years (Belgium starting in 1995, Ireland starting in 1991, Norway starting in 1999, Singapore starting in 1990, and New Zealand starting in 1994). Their circumstances are special. Most of these economies are unusually small and open. Belgium’s case was associated with the special circumstances of meeting the Maastricht convergence criteria. Norway’s was associated with North Sea oil and the decision to create a sovereign wealth fund. Our findings are not encouraging as we conclude that their experience will be difficult to replicate.

A surplus of ambition?

For the debts of Europe’s problem countries to be sustainable, absent restructuring, foreign aid or an unanticipated burst of inflation, their governments will have to run large primary budget surpluses, in many cases in excess of 5% of GDP, for periods as long as ten years. History suggests that such behaviour, while not entirely unknown, is exceptional. Countries that have run such large surpluses for such extended periods have faced exceptional circumstances.

On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected.

References

De Haan, J, R Jong-A-Pin, and J Mierau (2013), “Do Budgetary Institutions Mitigate the Common Pool Problem? New Evidence for the EU,” Public Choice 156, pp. 423-441.

Eichengreen, B and U Panizza (2014), “A Surplus of Ambition: Can Europe Rely on Large Primary Surpluses to Solve Its Debt Problem?” CEPR Discussion Paper 10069.

International Monetary Fund (2013), Fiscal Monitor, Washington, DC: IMF (April).

Kiel Institute of World Economics (2014), “Kiel Institute Barometer of Public Debt,” (March).