Italy’s public debt, decomposed

Why is Italy’s debt so high?

Is it because the Italian government was fiscally irresponsible, spending too much and taxing too litte? Or is it because investors demand such high interest rates on Italian government bonds? Or is it a consequence of Italy’s dismal economic performance in recent years?

To answer this question, we can take a simple decomposition of the debt-to-GDP ratio. First, remember the government budget constraint:  \displaystyle dB = G - T + rB. 

where B is public debt, G is spending, T is revenue and r is the interest rate. Second, take the time derivative of the debt-to-GDP ratio  \displaystyle d\left(\frac{B}{Y}\right) = \frac{dB}{Y} - \frac{B}{Y}\frac{dY}{Y}. 

Combine the two equations and denote the GDP growth rate dY/Y by g:  \displaystyle d\left(\frac{B}{Y}\right) = \frac{G-T}{Y} + (r-g)\frac{B}{Y}. 

This equation allows us to decompose the total change in the debt-to-GDP ratio into a primary deficit component, an interest component and a growth component. The graph below shows this composition for Italy during the pre-crisis period (2000-2008) and the post-crisis period (2009-now).


In the years between the introduction of the euro and the financial crisis, Italy’s debt ratio decreased slightly by about 2 percent of GDP. During the years after the crisis, it increased by almost 30 percent of GDP.

What changed? As you can see by looking at the yellow and blue areas in the graph, it wasn’t interest payments or the primary surplus. Interest payments were around 5 percent of GDP both before and after the crisis and the Italian actually ran a primary surplus in both periods. What changed was the green area: the recent rise in the debt ratio is almost entirely due to Italy’s shrinking economy.


A perfect prediction (self-congratulation)

Three years ago, Christoph Zwick and I wrote a paper about the sustainability of Austria’s public debt. Under our preferred model, we forecasted the debt-to-GDP ratio, which at the time stood at slightly over 80 percent, to recede towards 60 percent within the next decade. We concluded that the long-run probability distribution of Austrian public debt given current data indicated no cause for alarm. How good was our projection?

Well, the new Austrian minister of finance just held his budget speech, in which he announced a zero budget deficit in the coming years. Assuming the government follows through on this plans, this would indeed bring down the debt-to-GDP ratio to 62 percent, exactly as our main projection predicted.

Here is the finance ministry’s proposed budget path:

Bildschirmfoto 2018-03-21 um 09.00.09

And here our main projection from the paper (note that the initial debt level is slightly lower due to different definitions of public debt; the dark and light blue areas indicate the 75 and 95 percent probability bands around the median, which is in black):

Bildschirmfoto 2018-03-21 um 08.54.12

Ladies and Gentlemen, this is what a perfection prediction looks like.


Debt crises in a monetary union: the case of Indiana

As Europeans we tend to think of America as new, young, and modern, whereas in Europe everything is old and traditional. At least that’s what I thought, until I noticed this while driving around in the American Midwest:


The license plate celebrates the 200th birthday of the State of Indiana in 2016. 200 years! This means, in a sense, Indiana is older than many of the states of the European Union. In 1816, Germany was still a patchwork of small territories, loosely connected through the German Confederation – of which Austria was a part. Italy was merely a geographical description – the process of Italian unification had not even begun. Greece was just a province of the Ottoman empire. Belgium, until 1815 known as „Austrian Netherlands“, was part of the United Kingdom of the Netherlands. France did exist as a nation then, however, while the people of Indiana lived for 200 years under the same political system and only once made marginal changes to their constitution (more about this below!), the French during the same time went from the post-Napoleonic Bourbon monarchy to the Second Republic to the Second Empire, then back to the Third Republic, then to totalitarian rule under the Nazis, and finally back to Fourth and now the Fifth Republic. As far as I am aware, there is no European country which has had the same constitution for the past 200 years without interruptions or major changes – the single exception I can think of is the United Kingdom which always had the same constitution: none.

There is another striking fact about the history of Indiana. Indiana has been in a monetary union with the rest of the United States for as long as it existed. And during its early history, it has had its own debt crisis which bears a striking resemblance to the recent history of the much younger European monetary union.

When Indiana became a State in 1816, it was mostly a wilderness at the margin of civilization. The only major road in the country was the Buffalo Trace – literally a trace created by migrating bison herds. Population was only 65,000 initially, but growing fast. The government of the young state decided to take the country’s infrastructure into the 19th century. And 19th century infrastructure, they figured, was going to be canals. So, they launched a giant public investment program, called the Mammoth Internal Improvement Act, spending 10 million dollars (equivalent to 260 million current dollars, roughly 100% of GDP at the time) on canals and toll roads. The heart of the project was the Wabash & Erie Canal connecting the Great Lakes with the Ohio River. „Crossroads of America“  was the official state motto of Indiana.

To finance these projects, the governor of Indiana, a certain Noah Noble, had a plan: some money was to be raised by selling public lands, some by raising taxes, and some by borrowing from the Bank of Indiana, which was partly state-owned. The Bank of Indiana refinanced itself by issuing bonds, backed by the state, at the London exchange.

Initially, the plan looked like a big success. The construction works employed many thousands of people and provided a stimulus for the economy. Borrowing costs were low and spirits were high. But soon, problems started to appear. It turned out that the government had greatly underestimated the costs of building the canals, mostly because they failed to take into account the damage done by muskrats who burrowed through the walls of the dams. Critical voices in the State Congress regarded the canals as a total waste of money. Railroads, they argued, were the future! Nobody seemed to listen.

And then, in 1837, a financial crisis broke out. The crisis was triggered by the Bank of England which, in an attempt to curb the outflow of gold and silver reserves, raised interest rates. This had a direct impact on Indiana whose borrowing costs skyrocketed. It also had an indirect effect: since the United States was on a gold and silver standard, American banks were forced to follow the Bank of England in raising interest rates, which led to a credit crunch and a nation-wide recession. (A classic example of a monetary policy spillover effect!)

The combination of stagnant tax revenues, exploding construction costs and rising interest rates meant that State of Indiana was effectively bankrupt at the end of 1841. So they sent the head of the Bank of Indiana to London to negotiate a restructuring of the debt. The creditors agreed to a haircut of 50% of the debt. In exchange, Indiana handed over control of most of the canals and roads, many of them still unfinished. The Wabash and Erie Canal was held in trust to pay off the remaining debt. It operated until the 1870s yielding a low profit, but was soon made obsolete by – the railroads which turned out to be the key infrastructure of the 19th century.

The conclusion Indiana drew from this was that the long-run costs of government borrowing far exceed the short-run benefits. Which is why in 1851, they adopted an amendment to their constitution, forbidding the State government to get into debt (except in cases of emergency).

I’d say there is a thing or two our modern European states can learn from this story.

Monetary Policy Should not Care About Fiscal Policy

For some reason a fairly extensive part of the literature on monetary economics is dedicated on the “interaction between monetary and fiscal policy”. I am not sure what this means, nor why it matters at all. As a core idea, and again resorting to Friedman’s notion that Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, the level of inflation is 100% under the control of and thus determined by the central bank. The only additional assumptions required to make this hold is central bank independence, the importance of which has been long established, and at least some degree of central bank competence, without which we can essentially stop talking about monetary policy in general.

Let’s start from a point where a central bank is achieving its target, however defined. Now let’s bring in fiscal policy, and let’s say it tries to increase spending. Clearly this increase in spending would, momentarily, move the economy away from what the central bank is targeting, which would require central bank intervention to bring it back on track. In the end, for the macroeconomic indicators that are generally included in the objective function of central banks, the fiscal policy does not do much after the initial short-lived shock. The whole concept is essentially summarized by the concept of “monetary offset”, basically explained in this paper by Scott Sumner (.pdf).  This inability of fiscal policy to do much on a macroeconomic level in a world where the central bank actually does its job is a feature, not a bug. Fiscal policy should concentrate on achieving democratically determined goals, and as such it can legitimate alter e.g. the income and wealth distribution in an economy in order to bring them in line with this consensus view on what it should be, as well as give the central bank a different target if it so desires. The optimal target a central bank should be given very much depends on what is possible on a fiscal level, particularly in terms of the ability of governments to tax different things. Yet once that is determined, the central banks job is to make sure that whatever the fiscal authorities do does not move the economy away from the target it’s job it is to achieve. Apart from the target setting itself this is essentially a strictly objective task.

In other words the central bank will always dominate the fiscal authorities given the two basic assumptions I made. It should not be the job of fiscal policy to achieve these targets in the first place. If a situation arises where someone has to give in, it is always the fiscal authority that will unless at least one of the two assumption is violated. In terms of final macroeconomic variables targeted by the central bank (once its target is set) like the level of inflation or the level of NGDP, what fiscal policy does, or even its very existence, is irrelevant.