Are Government Debts Really Irresponsible?

Posted by Andy Wynne

Disclaimer: Andy Wynne, an independent consultant,  is the editor of the International Journal of Governmental Financial Management; the point of view he expresses in the following post is not necessarily shared by either PFM Blog or the IMF.

In recent years it has been assumed that fiscal discipline should be one of the main objectives of public financial management. Thus, for example, the World Bank cites aggregate fiscal discipline as the first of the three much quoted objectives for public expenditure management.1/ The European Union has set targets of 3% for annual fiscal deficit and 60% for government debt. Several countries are adopting fiscal responsibility acts which limit the fiscal deficits which their governments are allowed to apply when setting their annual budgets.

The financial crises in Mexico (1994-95), Southeast Asia (1997) and Russia (1998) brought extensive economic dislocation, fiscal hardships and liquidity problems for the governments of these countries. The debt crisis for the governments of many developing countries over the last two decades had a similar effect and made them dependent on policy advice from the World Bank and IMF. Having suffered these problems it is a question of once bitten, twice shy. Many governments now accept the need to constrain their public expenditure to avoid future debt problems. However, in doing so they may not undertake much needed investment in public infrastructure which could be essential to achieve optimal economic growth in the future.

Economic history actually indicates two possible scenarios resulting from high government debt. Unfortunately, it is only the negative one which is generally remembered. The alternative positive result occurred, for example, in the post 1939-45 war period in the UK (and the US). This indicated that, in suitable economic conditions, what are now considered to be unacceptably high budget deficits and government debt levels can actually lay the basis for sustained economic growth.

Both of these countries had government debts of over 100% of their GDP in the late 1940s, but this was followed by one of the most sustained economic booms either country has experienced before or since. In the US, the Federal debt alone (excluding state or local government debt) reached over 120% of GDP in 1946 and, in the UK, Government debt peaked at nearly 250% at around the same time. However, the sustained economic boom of the 1950s and 1960s meant that these levels of debt were sustainable, could be accommodated and were eventually repaid.

In the US, the Federal Government debt had fallen to below 50% of GDP by 1964 as the economy had grown so consistently, although the actual dollar amount of the debt had grown by over 15% over the intervening years.2/

In the UK, Government debt rose in during the second world war to a peak of around 250% of GDP in the late 1940s. This would currently be considered a catastrophic level of debt, but again proved to be sustainable. Despite consistent budget deficits of around 3% of GDP in the 1950s and 1960s, the UK Government debt had fallen to only 50% of GDP by 1975 and has remained around that level over the subsequent thirty years.

The steady and consistent decline in the level of debt relative to the GDP in the three decades after the end of the Second World War reflected a number of factors working in the same direction.3/

First, the very high level of the initial debt ratio meant that significant borrowing would have been required to maintain it at this level, given that national income growth was positive.

Second, post-war inflation persistently turned out to be higher than anticipated. Little inflation was factored into interest rates when Government bonds were sold in the middle of the last century. So the Government benefited from low effective interest rates on its debt.

In the 1950s, prices trended upwards, and this increased inflation accelerated during the 1960s. As a result, the real value of the (cash-denominated) stock of debt eroded.

Finally, real economic growth in these years was fairly consistently high by historical standards, so the relative importance of a fixed stock of debt to national income tended to decline rapidly.

In the case of both the US and the UK, governments borrowing linked to investment in public services and infrastructure had helped to lay the basis for one of the most consistent periods of economic growth these countries have ever seen. Thus demonstrating that, in certain circumstances at least, relatively high levels of government borrowing can be beneficial for the national economy.

The macro-economic demand for a balanced budget is also contradicted by the experience of developing countries during the decades immediately after the end of the Second World War. Thus, for example, research by two academics at Oxford University (Adam and Bevan, 2005)4/ shows an association between maximum economic growth and a government budget deficit of around 1.5% of GDP. In particular, they conclude that ‘deficits may be growth-enhancing if financed by limited seigniorage (printing of money). These results come from their study of 45 developing countries over the 30 years from 1945.

Unfortunately, the experience of many developing countries over more recent decades has been less successful. Their governments borrowed heavily in the late 1970s and then suffered from the twin effects of a substantial increase in the rate of interest levied on these debts and a world economic slow down in the early 1980s which reduced the value of their exports.

Around the same time, in the late 1970s and early 1980s the United States raised interest rates to nearly 20% in a battle to throttle back its persistent inflation.5/ The real (inflation adjusted) interest rates paid by developing countries increased from minus four per cent in 1975 to almost plus four per cent a decade later.6/

The rapid increase in world interest rates in the early 1980s on top of the oil price rises, led to a world economic recession. As a result most developing countries faced a reduced demand for their exports whilst having to pay higher prices for their imports coupled with much higher interest rates on their government debts.

As UNCTAD describes the effect on sub-Saharan Africa:

From just over $11 billion in 1970, Africa had accumulated over $120 billion of external debt in the midst of the external shocks of the early 1980s. Total external debt then worsened significantly during the period of structural adjustment in the 1980s and early 1990s, reaching a peak of about $340 billion in 1995.7/

The United Nations Food and Agricultural Organization 8/ estimated in 2005 that if commodity prices had maintained the same real value as in 1980, developing countries would be earning an additional $112bn in annual export revenues, which was double the current level of their aid receipts. Putting it another way, between 1970 and 1997 changes in the terms of trade cost non-oil producing African states (excluding South Africa) a total of 119% of their annual GDP, according to the World Bank.9/ External debt grew by 106% of GDP over the same period. So all the external debt of African countries at the end of the twentieth century could be explained by falling prices for their exports and increasing prices of imports – both changes over which their governments had little or no control.

Thus the actual impact of government budget deficits and the resulting debt are not as simple as the advocates of fiscal responsibility would have us believe. In certain situations, government debt at levels far in excess of levels which are currently regarded as prudent may have had a beneficial effect on the economy and have proved to be sustainable.

In addition, governments which restrict their borrowing may stop much needed public investment. For example, this year the Government of Lagos State is proposing to borrow 141 billion to fund an investment programme of 244 billion. If Lagos State were to have adopted a fiscal responsibility act on the same basis as the one adopted at the Federal level in 2007 then its annual budget deficits would be restricted to 3% of the local GDP. This would mean that that its capital programme for this year would have to be cut by around a third.

Lagos State has suffered several decades of under investment. Its road system is crying out for significant investment and a third of its children, the future work force, do not attend school. Given the fact that tax revenues are significantly increasing and Lagos State is expected to benefit from substantial increases in oil related Federal transfers why should vital public investments be restricted in the name of questionable financial sustainability and responsibility?

More generally, as the world economy suffers from the fall out from the American credit crunch, now is just the wrong time to restrict public expenditure. Private sector investment is being curtailed as companies re-consider the prospects for economic growth. If governments across the world reduce their expenditure and borrowing to the levels proposed by the advocates of fiscal responsibility we really will see a return to the global collapse suffered in the 1930s.

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1/ World Bank (1998) Public Expenditure Management Handbook, Washington DC, The World Bank

2/ Office of Management and Budget (2007) Historical Tables Budget of the United States Government - Fiscal Year 2008, page 126 (17 September 2008)

Clark, T and Dilnot, A, (2002) Measuring The UK Fiscal Stance Since the Second World War Briefing Note No. 26, London, The Institute For Fiscal Studies

4/ Adam, C.S. and Bevan, D.L. (2005). Fiscal deficits and growth in developing countries, Journal of Public Economics, No. 89, pages 571–97

5/ Stiglitz, Joseph (2006) Making Globalisation Work (page 220)

6/ Bond, Patrick (2006) Looting Africa, Zed Press (page 13)

7/ UNCTAD (2004) Debt Sustainability: Oasis or Mirage (page 5)

8/ FAO (2005), The State of Agricultural Commodity Markets 2004, UN Food and Agricultural Organization

9/ World Bank, 2000, Can Africa Reclaim the 21st Century?

Comments

[Soji Apampa]

This appears somewhat counter-intuitive, Andy. The arguments you present here appear reasonable given the assumptions you seem to have made. Let me ask, in zones of weak governance like Nigeria, Lagos State Government inclusive, where corruption is pervasive and operational and allocative efficiency weak, do you really believe that a Fiscal Responsibility regime has no place? Are our levels of spending sustainable? Lagos has much better levels of internally generated revenue than most states in Nigeria .... without a Fiscal Responsibility regimen, how do you determine what a sustainable fiscus size should be? You seem to assume that there is a direct translation of debt into public services without significant levels of loss and wastage. Nigeria is renowned for White Elephant Projects ... projects that get started and are never finished (sometimes because they were never meant to be finished) although there is absolutely no evidence that Lagos under Governor Fashola would embark on White Elephant projects, what do you advise other states who have performed poorly so far to do ... take on gigantic tranches of debt in realtion to their GDP? What GDP? Most states do not really produce anything nor do they generate any appreciable revenues internally and most are dependent on the federal transfers.
I guess, I am finding it really hard to swallow a wholesale jettisoning of a Fiscak Responsibility regime because your arguments do not tell us what we should replace it with and how especially for governments in our context.
What would you say are the effects of corruption and ineptitude on your proposals?

[Adekunmilola Adio-Moses]

Wonderful article, Andy. I discussed some of your points with my colleagues in the Lagos State Government. While it is instructive that significant Public Expenditure is crucial for growth and development in places like Lagos, Nigeria, there is general consensus that, when it comes to 'retail issues' or day-to-day delivery and management of public goods and services, government needs to increasingly allow private sector experts to take charge. This way, Government will be taken out of business and thereby be able to concentrate on the real business of governance.
-Kunmi

[Andy Wynne]

Soji is correct that corruption is a major issue in Nigeria (and a number of other developing countrie). This is, I think, a separate issue from the sustainability or otherwise of budget deficits and the resulting debt. However it is a widespread view across Nigerian civil society that government borrowing should be restricted because of the issue of corruption.

Corruption has to be dealt with and there are an number of tools which are being used to a greater or lesser extent in Nigeria, but getting out of the problem is not easy.

However, restricting government borrowing will not really help this issue, especially where the demand for public services is clearly so high. In Lagos more than one in seven children die before their fifth birthday and one in twenty adults are estimated to be HIV positive. A significant number of children do not receive any formal education and only just over half receive more than five years. In this situation, the government must invest heavily in health and eduction. And, if necessary, borrow to do this.

Fiscal responsibility is more than a balanced budget. As an article in the Nigerian Guardian noted this Sunday, "there should be a written law to force the government at different levels to set aside a certain percentage (say 40 per cent) of their total revenues for the provision and maintenance of good infrastructure and social servies for the populance they claim to serve." The article then went on to critice the salaries of senior politicians which have increased by 250 per cent in the last five years.

We need to ensure that when dealing with the problem of corruption that we do not throw the baby out with the bath water. We have to ensure that the corruption of some politicians in some governments does not result in the non-provision of public services which are so desperately needed in Lagos, as in most major cities across the world.

[muthu]

The present economic meltdown and crisis was bought about by the greed of merchant bankers and Turnbull was a merchant banker--that says it all, they dont care about the damage to the economy, just instant profits, Turnbull still has a lot to answer for to the mum and dad investors who lost their life savings in the HIH crash, he was head of Goldman Sachs and they reccomended HIH take over the worthless FIA, thats what caused the crash.
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Muthu