Friday 19 March 2010

Will this time be different? (Part II)

I continue today with the analysis of the Portuguese fiscal consolidation one century ago. In my opinion, Reinhart and Rogoff’s analysis may be biased by concentrating on the debt/ GDP ratio as measure of fiscal sustainability.
A first problem with this analysis is that it assumes that debt is an exogenous quantity with respect to the interest rate the government has to serve. As the public debt authorities in the PIGS countries have been reminded this is not the case. In normal working financial markets spreads (p) are related to the debt stock. For instance, if a country wishes to finance a € 1 deficit it will have to sell approximately € (r+p)/r in bonds, where r is a benchmark rate, such as that paid by the German Bunds. And if p increases with D (the debt level accumulated in the past), the service of debt may become unsustainable. Therefore, for a government the real burden of debt is not the size of the debt stock itself but its interest service (r+p)D.
A second problem has to do with the denominator of the debt/ GDP ratio. Governments are not usually able to lay claim to the whole of GDP, so the real measure of the government’s ability to repay is given by its capacity to tax. A better denominator for a measure of fiscal sustainability is therefore the size of government revenue.
Piecing this together, a more sensible measure of fiscal sustainability is the ratio between debt service (S) and government revenue (R):
where all variables have the same meaning as in my previous post and t stands for the aggregate tax level. Over the same period, debt service fell from 55% to 27% of public revenue. Figure 2 illustrates the decomposition of this ratio.
As to be expected, spreads turned against the Portuguese debt after the default and pushed the ratio up. Debt levels, and in particular the write-off of the external debt, are again mostly irrelevant on their own, and almost cancel out. The more salient result is that despite a positive contribution from economic growth (not to mention inflation), the bulk of fiscal consolidation came from a substantial increase in taxation, which explains more than 50% of the reduction in the ratio. The overall tax burden increased by 39% over this period.
Under this more sensible metric, Portugal was not able to grow out of its debt, but nor was it relieved from it by default, as Reinhart and Rogoff would suggest! It may be that Portugal was an outlier, by I believe this matter begs more research, especially considering the current discussions about the possible ways out of our current fiscal bind.

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