photo: Simon Cunningham
Low Inflation and Government Debt
Government debt typically refers to nominal GDP, generally rising in postwar Oecd countries. Last crisis was an exception, firstly displaying in 2009 a nominal recession affecting 27 out of 34 countries. To understand reasons and implications, I evaluate in Table 2 for six Oecd countries (US, UK, Germany, France, Italy and Spain) how in last crisis the Debt-to-GDP components changed their weight with respect to previous 2000-07 evidence.
Table 1- Cumulated % Changes in the 2008-13 Crisis
The Deficit/GDP share almost doubles in the 2008-13 years in which the average Debt-to-GDP ratio, about constant before, rises more than 50% with respect to the 2000-07 data. Thus, the deficit contribution to the debt increase jumps from 47% to a massive 87% share.
Looking at annual episodes, the deficit weight is very large in 2002-3 when the debt ratio starts to increase after the 2001 events. However, it is only during the Great Recession that the deficit weight deeply rises because of expansionary policies, maintained until recovery is achieved.
Calculating debt generating sources, the share of the average GDP deflator is strongly reduced with respect to the 2000-07 years in which the nominal GDP denominator accounts for about 40% of the overall Debt-to-Gdp changes: a figure falling about five times in the next period! This happens because, similarly to the inflation share, also the weight of the real GDP changes almost disappears in the crisis years: results in the 2008-13 period are then mostly based on the dominant deficit share that makes irrelevant nominal GDP components as when a rising deficit is driven by policy discretion, explicitly reacting to negative shocks.
Results are milder but roughly similar to those found for the US since in the crisis years the UK deficit share grows less and is smaller. Accordingly, the deficit weight strongly rises in the 2009 recession peak, decreases in the next two years to increase again in 2012-13 when growth is still low.
During the crisis, the price component of the debt changes is also reduced despite the average inflation is about the same in the two periods. Further, in the 2008-13 years real growth share strongly diminishes because stagnation lasts more than in the US. Combining price and real growth performance, it is not surprising that nominal GDP does not really account for the debt ratio increase in the crisis years. Finally, in the UK there is also a major weight of the Other variable that here summarizes all residual sources behind Debt-to-GDP changes.
In the crisis years also in Germany the debt ratio rose though less than elsewhere. Germany’s case is peculiar, being here the only country in which the deficit share was bigger in the first period when the country had to face unification and modernization costs: actually, in the 2000-07 years the deficit weight provided almost the 60% of the debt ratio changes, widely exceeding nominal GDP share. In particular, the deficit share was higher between 2002 and 2005 when Germany did not comply with the 3% Maastricht rule, possibly to sustain the unified economy. Conversely, the debt increase in the 2008-13 years is scarcely related to the deficit weight which is much smaller (12%) than it was before (58%).
Another peculiar result is that the largest portion of the 2008-13 debt changes belongs to the residual component (Other) which, however, is by itself difficult to interpret. Finally, as far as the nominal GDP is concerned, the real GDP share remains the same in the two periods while the inflation weight increases in the second, mostly because of the anomalous 2013 result.
As a whole, debt decomposition in Germany seems to be counter-cyclical only in the 2000-07 years since afterwards the macroeconomic policy was apparently aiming at controlling inflation and a debt ratio that was even declining after the 2010 peak.
In France the debt ratio was acceptable according to Maastricht rules in the 2000-07 period. Unlike Germany, however, in the 2008-13 period the deficit ratio increased because of a more countercyclical fiscal policy that, however, did not succeed in stimulating the economy as it was probably hoped. Finally, as in other cases here, the nominal GDP weight falls in the recession years since both inflation and real growth shares are reduced.
Actually, debt decomposition shows that adjustment in France was more straightforward than in Germany since in the 2008-13 years the debt ratio increase almost parallels the deficit ratio increase as implied by countercyclical fiscal policies. Thus, the dominance of the deficit weight is large, not occasional, and holding also in the 2000-07 period in which debt changes were – as in general here – smaller and even negative in three cases.
In France real GDP growth was, however, missing in the crisis years while inflation was – as in most cases here – lower than before. Thus, nominal GDP was unable in the 2008-13 phase to compensate for the expanding debt numerator. This also explains why the deficit component became so large after 2008, given also the small weight found – unlike Germany – for the residual component (Other).
Here, Italy has a special position for having the highest debt ratio even before the crisis began. This high-debt heritage certainly reduced the available fiscal space, limiting the possibility of contrasting the Great Recession within the EZ framework. As a result, almost no fiscal discretionary intervention occurs in the 2008-13 years, characterized not only – as in most OECD countries – by a negative real growth in 2009 but also by a nominal recession in the 2012-13 biennium.
The large inherited debt severely constrained fiscal policy, leading to the apparent paradox that Italy is here, along with Germany, the only country running a primary surplus in most of the crisis years. Further, given the EZ surveillance, the deficit size rose in the 2008-13 period less than elsewhere. Despite that, Italy’s debt ratio was, however, rising in the crisis years also because – among the denominator components – the low inflation did not offset real GDP contractions in three out of the six possible cases. Yet. the deficit weight on debt formation increased only slightly in the recession period.
Italy is also the country in which real growth component still matters in the 2008-13 years, though this paradoxically happens because the average GDP growth falls in real and is about constant in nominal terms: hence, the debt-to-GDP ratio rises despite government deficit is broadly in line with the EZ 3% rule!
Spain is here the case in which the difference between the two periods is largest and the recession cost apparently highest. Thus, the debt ratio is basically V-shaped, reflecting in the first part not only a low but also a decreasing Debt-to-GDP ratio. This process is reversed in the 2008-13 years in which the ratio almost doubles, blending in a peculiar way strong deficits, long recession and declining inflation.
Debt sources for Spain are shown in Table 2: the deficit weight, slightly exceeding the 10% in the 2000-07 period, jumps to 95% in the crisis years, becoming in practice the only relevant source of the debt increase. In the 2008-13 period nominal GDP components are less important as a result of an inflation even lower than in Germany and of a negative real growth in four out of the relevant six years and on the average as well. Finally, residual factors (Other) are negligible, confirming again that in Spain most of the debt ratio increase originated from the large deficit increase.
I evaluate for six OECD countries the sources of government debt increase during the Great Recession vis-a’-vis the years immediately before. This is done adopting a simple accounting scheme, decomposing annual Debt-to-GDP % changes into their numerator (deficit, discrepancies) and denominator (inflation, real growth), independent components.
The annual sample compares the Great Recession (2008-13) to the preceding 2000-07 years to evaluate if and how last crisis affected the Debt-to-GDP changes. The Great Recession impact is apparently similar everywhere if attention focuses on the timing rather than on the size and nature of the debt response. Conversely, disentangling between the sources of the Debt-to-GDP increase, the evidence shows that they were more or less large between 2008 and 2013-13 years but not necessarily stemming from deliberate policies: actually, our results indicate that there was also – with the exception of Germany – a general reduction of the nominal GDP weight, due to the concurrent mix of low inflation and low – or even negative – real growth.
In the crisis years, this mix made debt ratio changes more asymmetric than they were before since the fiscal numerator was no longer compensated by a denominator, usually rising in both inflation and growth components. Thus, last Debt-to-GDP increase cannot be ascribed only to an excess of fiscal activism in critical times.
Decomposing by source the Debt-to-GDP % changes, results basically indicate three fiscal responses to the Great Recession:
- 1. There is a specific German response aiming at minimizing fiscal adjustment, probably because the crucial one occurred before: when the country had to face unification costs and reforms that proved to be useful later.
- 2. The other EZ countries show fiscal policies ranging from debt-induced discipline (Italy) to several degrees of accommodation (Spain, France), allowed by the EZ rules. Yet, in all cases the 2008-13 debt ratio changes reflect an increasing deficit weight: huge in Spain, big in France and moderate in Italy because of its debt-constrained fiscal policy.
- 3. The last response involves the US and, partially, the UK: here, the only two cases where the Great Recession induced debt changes reflecting a temporary, counter-cyclical, policy that neatly differs from the EZ mix of common inertia and ad hoc heterogeneity.
Table 2 – Government Debt % Changes and Sources