Can the debt be cut?

Italy, Belgium and Greece have been sharing some major common problems in the European Union (EU) for years, that is, the highest debt levels and an aging population. But unlike Italy and Greece, Belgium appears to be breaking away from the pack and reducing its debt level by sticking to a disciplined fiscal policy for some 10 years now. With Italy looking set to succeed Germany as the EU’s sickest man, Greece has the best chance to follow Belgium’s example but it needs the two major political parties to agree on the main goal of rapidly reducing the country’s high debt level to approach the 60 percent of GDP target in less than 10 years. The role of the public debt level is important for the long-term sustainability of public finances because it has a strong dynamic of its own. Once it starts going up, interest payments rise and the budget deficit can easily get out of control as the examples of Greece and Italy show. Remember it took only 10 years for these two countries to see their debt levels rise by more than 50 percent of GDP.  The Belgian example Belgium itself went through a period of some 20 years of running huge budget deficits. The budget deficits, averaging about 7.0 percent of GDP, helped push the Belgian public debt close to 140 percent of GDP about 11 years ago. However, thanks to consistent prudent fiscal policies followed by successive governments, the debt ratio is expected to fall to about 95 percent of GDP this year, according to Chris Pryce, an official at the credit rating agency FitchRatings. Can Belgium reduce its public debt ratio close to 60 percent of GDP envisioned in the Maastricht Treaty? The record of Ireland shows that this is possible. It took Ireland about 15 years to cut its debt level by about 80 percent of GDP. What does the fiscally virtuous example of Belgium show? A high debt level country has to run large primary budget surpluses – that is, the government budget deficit excluding interest payments – to be able to arrest debt dynamics and reduce debt faster. Despite some slackness in the last couple of years, Belgium has succeeded in doing so by running primary surpluses averaging 6.5 percent of GDP in the last eight years or so on a combination of rising revenues and spending cuts till 2000. Of course, fiscal consolidation has been aided by one-off measures, such as a tax amnesty. However, one has to bear in mind that the Belgian economy has been expanding at below potential GDP growth rates for years, meaning one-off measures helped make restrictive fiscal policy less painful than it would otherwise have been. What has Greece – which, along with Italy, spends more on pension and health care expenditures as a percentage of GDP than Belgium – done over the same period? Not much. Even though the Greek economy has been growing faster than most of its EU counterparts since 1996, its public debt ratio has not dropped below 100 percent over the same period. The Greek debt ratio is not expected to fall to 99.9 percent of GDP before 1997 from a projected 108 percent this year, according to Greece’s updated 2004-2007 Stability and Growth Program. The reduction is assumed to take place while the economy is seen expanding by more than 3.5 percent during the same time span. The main reason behind the insufficient progress is clear when one looks at the evolution of the primary budget balance. The general government primary budget was in deficit in 2004, accounting for 0.4 percent of GDP, the same year the economy grew by 4.0 percent. It is estimated to turn into a surplus in 2005, 2006 and 2007 – but at 1.9 percent of GDP, 2.6 percent and 3.2 percent respectively. One can understand why debt reduction does not proceed as fast as it should. Nevertheless, debt reduction should be viewed as a high priority by the two major political parties in Greece, the conservative New Democracy and the Socialist PASOK, in view of the country’s dismal demographics and high pension and healthcare spending. Greece is projected to pay 12.4 percent of its 2005 GDP in pensions and some 5.0 percent of GDP in healthcare without counting the health costs of the elderly. High pension costs Pension payments are expected to eat 17.3 percent of GDP in 2030 and 22.6 percent in 2050 while health costs are projected to rise to 5.9 percent in 2030 and 6.6 percent in 2050, according to EU and national actuarial committee estimates.   It is clear that Greece cannot continue to make similar interest payments to service its huge public debt and find the extra resources to fund the rising pension and health care costs in the year to come. Doing so, it will come at the expense of economic growth and the creation of a vicious cycle which will threaten the foundations of the economy and undermine the standard of living of its citizens. With yields on government bonds again on the rise, running large primary budget surpluses as a percentage of GDP and collecting more revenues from privatizations becomes imperative to absorb the higher interest payments and take advantage of the satisfactory GDP growth rates. But running huge primary budget deficits entails political costs for whichever party is in power. This requires that the two major political parties agree on the main goal of debt reduction and the broader guidelines to achieve it and leave room to disagree on specifics. They should therefore look to Belgium, where successive coalition governments stuck with fiscal consolidation, for drawing conclusions along with inspiration. If this does not happen, then it is likely that progress will be insufficient and debt levels will spiral out of control down the road.