LECTURE 1: “FISCAL POLICY AND STABILIZATION POLICY”: Public Debt

and Deficits

FACTS AND FIGURES

Issues measuring public debt:

- Only federal government or also local government, maybe even full public sector?
- Should assets be taken into account? If so, which? And at which value?
- Should future liabilities be taken into account? If wo how to discount?
- Business cycle Corrections?
 Down terms of the business cycle: We might have

 If the definition is way TOO NARROW:

Then governments will understate their debt and ENCOURAGE SHIFTING OF SPENDING TO
ENTITIES OUTSIDE THE DEFINED PERIMETER.

 If the definition Is way TOO BROAD:

Definition is susceptible to mismeasurement of on-balance sheet assets and liabilities

The exact definition of Government Debt that you use: Truly matters

GOVERNMENT DEBT (As a % of GDP, current)

Depreciate my currency so the debt can be worth less

 Strong relationship between the political color and the Change of

DEBT/GDP RATIO

Oil Rich Countries: They Do Not need to borrow

- In either to borrow
 Want to borrow
 Have access to international financial markets

- Not all countries need to Borrow (Oil-rich)

 Not all countries CAN borrow (Unstable governments: Puerto Rico,
Sudan)
S&P Credit Rating and Outlook (current)
- Credit rating: How likely it is that a country will Not pay back its
debt.
- The more riskier a country is: The higher the risk premium the
country should pay

 Australia: GOOD: AAA

 Italy: BBB: 3.7% YIELD
 Germany 2.4% YIELD
 Netherlands: 2.7% YIELD
Why this difference?

- LIQUIDITY: Sell German or Dutch bond: How difficult is it to sell

those bonds?
German bonds do not have much liquidity risk (Easier to sell the
bonds) so the liquidity premium for German << Dutch

- Why is there are difference in YIELD betwwen

HIDDEN DEBT:
PUBLIC DEBT ONLY INCLUDES CURRENT OUTSTANDING DEBT
Does NOT include PROMISED PAY-OUTS
- You know you will have to pay the money of these programs to
people: However, they are NOT included in the Current Outstanding
Debt
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Case: HIGH PUBLIC DEBT (GREECE)
(0) Reports that Greece had hidden their real level of Public debt
(1) Collapse of TRUST in Greece financial system
(2) 10-year bond yield “SKY ROCKETED” until approx. 35% around 2012
 You have to pay a really high Interest Rate because your RISK
(Default Risk,
SELF-SULFILLING PROPHECY:
 Countries are unstable so they start borrowing a lot
 Debt Increase: HIGH DEBT  INCREASES RISK PREMIUM
 Debt Becomes harder to pay: They May Not Pay
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HIGH PUBLIC DEBT:
 If public debt is way too high: Fueling of inflationary expectation:
INFLATE DEBT AWAY:
 Solution (Money and Banking): Inflation linked bonds
Interest rate of bonds is linked to inflation

 High Debt may LOWER INVESTMENT and RATE OF ECONOMIC

GROWTH
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SUMMARY:
 Public Debt can be represented as a fraction of GDP

 Public Debt (as a fraction of GDP) varies over time and between
countries
If Low Debt/GDP Country
(1) Rich Oil country that does Not need to borrow
(2) Really poor country that does Not have access to international
markets
(3) Most Governments BORROW to pay part of its spending

 Definition of Public Debt is TRICKY

- Issues Measuring Public Debt
(1) Whole Public Debt (Federal + Local) or only Federal?
(2) Should Assets or Future liabilities be taken into account?
(3) Business Cycle Corrections?

 If the definition is TOO NARROW: Public Debt is understated and

governments will be encouraged to Shifting of spending outside the
defined perimeter
 If the definition is TOO BROAD:
Definition of Public Debt is susceptible to Mismeasurement of
ON*balance sheet assets and Liabilities

 Public Debt: Credit Rating

- Different countries have different credit ratings (AAA, BBB, ….)
indicating how likely it is for a country to pay back its debt
- YIELD (Risk Premium) varies between countries:
 Higher Risk of Default = Higher YIELD
 Higher Risk Of liquidity (less unease to sell the bond = Higher YIELD

 Public Debt May spiral out of Control

 Risk Premia
  Incentives to Increase Inflation

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DEBT DYNAMICS

PUBLIC DEBT: DEFINITIONS

Debt Service: Interest on debt: Id
* The interest rate is the cost of debt for the borrower and the rate of return for the
lender. The money to be repaid is usually more than the borrowed amount since
lenders require compensation for the loss of use of the money during the loan period.
* The normal interest rate you have to pay or receive for borrowing/lending respectively

Primary Deficit: Government spending (excluding debt service) - minus -

Taxes Revenues (G – T)
Total Deficit: Primary Deficit + Debt Service (G-T) + iD

Primary: Something You have to pay anyways

Total Deficit:

NEW DEBT = Old Debt + (Spending – Income) + iD – i

- The debt I already had to paid + (Lo que me pase the spending este period) + (The
interest Rates you have to pay on your debt (from last period)
CHANGE OF DEBT-GDP RATIO

GDP (Y), Government Revenues (G) and Tax Income (T)  Grow at real rate g (real growth)
plus inflation

I do Not care about level of DEBT (D), I care about DEBT / GDP RATIO

(1) Divide Equation / GDP

Split Current

(g + pi) = Nominal Growth

(1 + Nominal Growth) * Old GDP = New GDP

- Same as divding whole equation by Y

Change of DEBT/GDP RATIO

= (Primary Deficit) / Y + (Nominal Interest Rate – Normal growth)*(Last Debt

If I am to the left of the (Stable point : It is when the Debt/GDP ratio has not changed)

Then My previous Debt is Less: So My change will be POSITIVE

 LEFT OF THE (D/Y)*

My old (D/Y) is way too low and therefore the change is positive and I will move
towards stable point (change is 0)
 RIGHT OF THE (D/Y)* (Stable level of Debt/GDP ratio) that means that my (-1) last level
is TOO HIGH and therefore the Change of the Variable is negative: Which means I will
start to whrick until (D/Y) * (change is 0)

You always converge to that point)

FIND THAT OPTIMAL POINT (IS WHEN CHANGE IN D/Y = 0)

(I – g – inflation) is <0 so (D/Y)* is positive and stable

 You always converge to that point

(i-g-#)

i (nominal interest rate) < (g+#) (nominal growth)

  IF i (NOMINAL INTEREST RATE) > (g + #) (NOMINAL GROWTH)

 Line Upward Sloping

 If I am above the stable point (D/Y)* : Level Increases but Change Increases
DIVERGE TO INFINITY

So whether the DEBT / Y (GDP) is stable or Not, depends on our slope: (i-g-#)

(Nominal Interest rate – Nominal Growth rate) < 0 : NEGATIVE

Then the debt ratio is stable and will converge to its optimal point (*) (when change is 0)
If I > (g + #) then it is UNSTABLE: Because If the level of GDP Increases (to the right), then The
change will be positive, and D/Y will DIVERGE (CONTINUE GROWING(

ISSUE: Diverge to +INFNITY

 At one point, FIRMS WILL NOT HAVE TRUST IN YOU ANYMORE AND THEREFORE
Your slope positive, you are on the right of the optimal point, then you will Diverge.
 What Can I do about it? i should be < g + Inflation
 You can Increase inflation

If you announce that you will see that people will react with more expected inflation and I will
grow anyways
Let’s Imagine that I am in an UNSTABLE + UNSUSTAINABLE situation such that

 i>g+#
 and (D/Y) is to the right of (D/Y)* (where change in Debt/Gdp ratio = 0)
 Since My slope (i-g-#) is positive, my (D/Y) level will Grow and diverge towards
POSITIVE INFINITY

What Can I do about it?

I could lower my intercept (G-T) / Y such that my new line crosses exactly in the optimal level *
and (D/Y) is NOT CHANGING anymore

(G-T)/Y: PRIMARY DEFICIT SHOULD DECREASE to keep urrent Debt-Gdp ratio constant
When you think you are dealing with a STABLE SITUATION because i<g+#

Always check for the Convergence value (D/Y)* which will be when Change = 0

 Using Primary Deficit (=1%)

 It may be 500%

Country will demand RISK PREMIUM, NOMINAL INTEREST INCREASES – SITUATION

RICARDIAN EQUIVALENCE

Basically we have a DEBT/GDP EQUATION

 Primary Deficit: If it increases, then the CHANGE in D/GDP will
increase
 If i (nominal interest rate) Increases then the CHANGE in D/GDP will
increase as well (Because I am paying more interest on my debt)
 If (g+inflation) Increase then the CHANGE IN D/GDP will Decrease
(Because these account for Y(GDP))