Euro Countries – Meager Public Finances Part I
The industrialized countries, with the United States and Europe at the forefront, were hardest hit in the first worldwide economic downturn since World War II. The years from 2003 to 2007 were characterized by low interest rates, high growth, strong optimism, rapidly rising house prices and housing construction, and large debt borrowings in both the private and public sectors. The borrowers were emerging economies, led by China, with large export surpluses. They used the revenues to save and finance the high growth in demand in the western economies. Debt in many countries reached a level that proved unsustainable as interest rates eventually rose again, and growth slowed.
- Why do many states have to save now?
- Why are interest rates so high for some countries?
- What has been done to alleviate the situation?
- What is the future of euro co-operation?
The financial crisis hit hard in the autumn of 2008, and from the beginning of 2008 to the spring of 2009 the value creation of the industrialized countries shrank by more than five per cent, while unemployment increased from 35 to 48 million.
The government reacted on a large scale and helped to curb the fall. Systemically important financial institutions and banks, in some cases also particularly important companies, received financial support from the state in order to be able to maintain their operations and functions. Central banks bought securities that were difficult to trade in the nervous markets. Tax cuts and expanded labor market measures, increased public consumption and government investment contributed to stimulating increased demand.
The measures cost money, and in the vast majority of industrialized countries, public budgets ran large deficits . Thus, in reality, a transfer of debt from private to public hands took place. The debt burden of the states increased sharply. In 2007, before the crisis occurred, the gross debt of the industrialized countries accounted for just over 70 per cent of their gross domestic product (GDP). In 2011, it exceeded 100 percent of GDP. Some countries stand out with particularly meager government finances. Greece has a debt of almost 140 percent of GDP. Japan has a record of over 200 percent.
2: High debt is not negative in itself…
Like individuals, a state will want to distribute income and expenditure over time. Norway was dependent on borrowing funds abroad when we developed our oil sector in the 1970s. As oil revenues flowed in, we have gone from being borrowers to being a major lender through the Petroleum Fund. Having a large debt can make sense, if the prospects for future income are good.
For example, many emerging economies that are in the starting pit of industrialization will be characterized by high growth. Thus, they can take up debt, and then “grow out” of it. If a country also has strong institutions, with a good ability to collect tax revenues, this contributes to increasing their ability to service the debt.
… But dangerous if the “snowball effect” is triggered . If the growth prospects are weak and the interest rate level is high, the debt burden can be very heavy to bear. In the worst case, debt growth can get out of control.
Developments in a country’s government debt, measured as a share of gross domestic product (GDP), depend on two factors:
- New debt borrowings. If public expenditure exceeds revenue, there will be a deficit in the budget (the primary balance will be negative). These must be financed with new debt borrowings.
- «The snowball effect». If the interest rate is higher than economic growth, debt as a share of GDP will grow, even withoutnew debt borrowings. The larger the debt you already have, the more the debt rises.
If the snowball effect starts, it is necessary to initiate comprehensive savings measures to prevent the debt from growing uncontrollably and becoming impossible to manage. By cutting spending and increasing tax revenues, in order to make significant surpluses on public budgets, the debt level can be stabilized again.
3: Evil spiral
- High debt results in low growth Studies suggest that when gross government debt exceeds 90 per cent of GDP, economic growth weakens, partly because this can lead to high government interest rates that dampen private investment and weaken the growth potential of the economy.
- High debt and low growth yield high interest rates
Government lenders are increasingly international investors looking for returns, in this case a lending rate, on their funds. After World War II, government debt has been regarded as an almost risk-free investment. That has changed now.
Debt in several countries has reached such a high level that lenders have become concerned that the borrower, in this case a state, cannot repay what it owes. There may be good reason for such concern. There is no supranational institution that can collect debt when a state chooses or is unable to pay its loan obligation. In history, we have seen many cases where states have defaulted on their debt, but so far all industrialized countries have managed their debt after 1945.
Fear of default means that investors demand to be paid more to lend money. As concerns about public finances intensified in the autumn of 2009, and Greece was exposed for systematically underreporting its government debt, interest rates rose sharply on the debt of the most vulnerable countries.
In the spring of 2010, unrest intensified, and interest rates soared. As of March 2011, Greeks have to pay almost 13 percent in annual interest to take out loans with a ten-year term. This is almost 10 percentage points more than the Germans have to pay to take out equivalent loans in the markets. One year earlier, before the turmoil over the government debt burden increased in the early summer of 2010, they had to leave with only three percentage points more.
4: Aid measures from the EU and the IMF
A sky-high interest rate means in practice that you are excluded from the loan markets. Greek authorities were forced to turn to the EU and the IMF (International Monetary Fund) to cover their immediate financing needs. They received a three-year loan worth 110 billion euros. There are very strict conditions attached to the help. The Greeks must implement major budget cuts and reform the economy. The cuts cost, in the form of a continued economic downturn, increased unemployment and social unrest.
In order to restore investor confidence that other vulnerable countries could also service their loans, the IMF and the EU jointly established a crisis preparedness fund. In total, it amounts to 750 billion euros. In November 2010, Ireland also had to apply for a loan from the crisis fund. There is good reason to expect Portugal to be second out. These three countries are small.
Together, according to INTERNETSAILORS, Greece, Ireland and Portugal account for only six percent of the eurozone’s total value creation. If Spain is forced to seek funding, the amounts that the other euro area countries will have to contribute will be much higher. Then it can be very challenging to get the other member countries to stand up.