More Fiscal Arithmetic
This post was written by Colm McCarthy
On this recent thread
Karl Whelan points out that the 0.5% deficit/GDP rule envisaged in Friday’s ‘fiscal compact’ eventually yields a debt ratio at only 17% of GDP. This happens whether you start from zero or from Greece. Karl’s assumed growth rate is just 1%. If you assume 2% the debt ratio asymptotes to only 10%.
This helps to understand where the unlikely average deficit figure of 0.5% came from. The more natural choice of 0% yields the asymptotic abolition of the sovereign bond market, currently being pursued on a shorter time-scale by other means. Asymptotic abolition cannot be acknowledged in such an important (they were awake ’til 4 am) communique. Somebody might spot it.
The Maastricht 3% deficit, were it the annual average, yields an asymptotic debt ratio of 60%, with nominal GDP rising at 5%. But 3% is to be an upper limit in this fiscal Nirvana, and so is the 60%. Summiteers were thus posed with the following very tricky problem: how to add an average deficit ratio to the 3 and 60 from Maastricht without looking ridiculous?
The figure cannot be too high, since it would be too close to the 3% upper bound, and cannot be too low, since it abolishes the bond market (slowly). You are not allowed to ask why the extra average deficit rule had to be added to the Maastricht limits at all. This was a frightfully important summit, and tough new fiscal rules had to be imposed, to save Europe….
Actually the decline from 100% (possible peak debt/GDP ratio for the Eurozone as a whole) at a deficit of 0.5% per annum is pretty slow - takes 20 years to fall below 80% - so plenty of time for more summits. Karl goes on to hint that an ultimate debt ratio of 50% or so might be more prudent than 17%, without giving reasons. Here’s one.
Basel III has spawned something called CRD 4, capital and liquidity proposals for European banks. The liquidity part does not (yet) specify a quantitative ratio of liquid to total assets but could turn out to require 20% or 25%. If balance sheets end up at something sensible like 150% of GDP (UK currently 400%), this implies say 35% of GDP needs to be available as high-quality liquidity. Aside from central bank money, this means short (< 5 yr) sovereign bonds. It can’t all be central bank money (or if it can, explain how monetary policy would work). If the debt ratio drops much below 50%, sovereign debt duration has to drop dangerously.
There are reasons for not having too many sovereign bonds about. There are also reasons for not having too few. No thought appears to have been given to this 0.5% rule, about the only concrete element in the ‘fiscal compact’.