Events on the European stage are moving fast as the new Greek Government continues to play a blinder on the question of European debt. The eyes of Europe and the world are on Greece. The stakes are very high and this could go very well or very badly for Europe as events and talks play out over the coming months. Behind the developing political situation is the hard work of professional economists in working through what a debt re-structure might look like. A number of different suggestions and possible options have been put in the table including a paper written by Dimitris Sotiropoulos (whio was in Dublin over the weekend gone by), John Milios and Spyros Lapatsioras [SML] (“An Outline of a Progressive Resolution to the Euro-area Sovereign Debt Overhang: How a Five-year Suspension of the Debt Burden Could Overthrow Austerity 
”). The key aim of the authors is in this paper is that it ‘puts forward a plan for solving the sovereign debt crisis in the euro area in line with the interests of the working classes and the social majority’. In this Blog I focus on what this particular proposal might mean in simple-to-understand terms for a wide audience.
The first thing to point out is that, in the SML paper, there is no suggestion of debt write-off. This might be surprising because much of the discourse has been framed around the idea that the Greek people would receive a write-off debt.
The second point to note is there is no suggestion of money being transferred from one set of taxpayers (say German or Irish) to another set of taxpayers (say Greek or Spanish). This is a sticking point in the political debate in countries like Germany, the Netherlands and Finland.
So what is the fuss about? The key part of the current debate over debt is that there is a lot of it in Europe with many countries having stockpiled more public debt than annual income. In other words if you were earning €40,000 a year your total debt would be over €40,000 (and this would surely not be unusual for someone on a mortgage). One big difference between a householder and a nation state is that a nation state, strictly speaking, never pays back debt. True, it pays back debt by way of a principal and the interest cost on the outstanding debt (just like any mortgage holder). However, at the same time it takes on new debt – short-term and long-term to replace old debt. This is the way Governments fund capital spending, short-term deficits on current spending (if they have one) and pay off old debts and the interest on outstanding debt. Paying interest on debt is referred to as ‘servicing debt’.
Germany, for example, paid the last monies owed on its debts from after World War 1 in 2010. However, in the meantime, it had taken on new debts and replaced the old debt with new debts such as government bonds.
We have to bear in mind three important things when considering debt:
- The change in the level of prices
- The ‘real’ growth in incomes from which debts are serviced or paid back
- The annual interest rate on loans
Right now, price increases are unusually low, incomes (the GDP in each country) are fairly stagnant and interest rates are extremely low (even ‘negative’ in some cases). Normally, price increases (remember the rapid inflation of the 1970s and 1980s) and real growth in incomes (recall annual growth rates of 5-10% per annum in GDP in the 1990’s) took care of debt. What economists call the ‘nominal’ value of debt remained the same or even increased slightly while the ‘real’ value (what something costs or is worth when you allow for price inflation) fell. On top of that as incomes rose the value of debt as a proportion of income fell as the years went by. It was as if your income had jumped from €20,000 to €40,000 over 10 years reflecting rising prices as well as the real value of your income and your total outstanding mortgage card debt fell from €50,000 to €40,000. The end result is that debt relative to income fell from 250% of your income to 100%. That’s how public debt works over long historical periods (especially during periods of sustained economic growth and price inflation).
A little bit of inflation does not go amiss and when, occasionally, prices get stuck as in deflation or near-deflation a mild laxative can do the trick. That’s why the European Central Bank recently announced ‘quantitative easing’ where national central banks are allowed to buy bonds on the money markets (in other words to ‘print money’) and stimulate the flow of money in the economy with the effect of stimulating demand and restoring a modest increase in prices (so it is hoped).
The humanitarian crisis that has hit Greece in recent years is the result of a mix of factors: poor domestic policies and poor European-wide policies. Much of the ‘adjustment’ has been on those least able to bear the brunt of austerity in Greece while privileged sectors and individuals have continued to avoid paying their fair share of tax. Even though there is some measure of national responsibility (at Government level) for the high levels of debt, in Greece, Just as in Ireland it is not in the interests of the member states of the European Union to see Greece or other States continue to suffer punishment. It will not benefit economic prosperity or social cohesion in any part of Europe to continue to impose such burdens (unjustly and unwisely) on nations such as Greece. It is time for European solidarity – not just Greek or Irish. Let the talking continue.
What is proposed in the SML paper?
SML propose that the European Central Bank takes on a portion of excess public or sovereign debt in the case of each Eurozone country (of which there are 18 including Ireland and Greece). Any public debt that that exceeds 50% of GDP in each case is warehoused in the ECB for a long period of time. The ECB buys up this debt and turns it into very long-term bonds with a zero rate of interest. This would be like taking a portion of your mortgage which, say, is more than your annual income and transferring that to a frozen loan on which there is no interest payment for many years. To use the example, above, we have:
- Total mortgage = €50,000
- Total income = €40,000
- Mortgage transferred to a frozen account = €30,000
- Total remaining mortgage on which interest is paid = €20,000.
Such a measure helps those countries with high debts to lower their annual repayments/debt service costs (your monthly mortgage payment to use the example) and gives them breathing space to restart their economies, build up income and grow. It is also possible, but by no means certain, that price increases will feed into higher incomes and lower the real value of the outstanding debt in the longrun. To use Minister Noonan’s example, in 2013, of a teacher who bought a house for £3,200 in 1968 and took out a mortgage to find that one month’s salary would pay for the whole house when the mortgage ran out in 1995. Of course it should be noted that price inflation trends in the 1970’s and 1980’s are no guide to price developments in the Eurozone in the 2010-2020 period or beyond.
In the example used by SML (page 19), total working public debt in the Republic of Ireland falls from an estimate of €203 billion in 2013 to €82 billion at the same level of GDP. A parking of debt on this scale could significantly reduce the annual cost to Irish taxpayers of servicing debt. Conservatively, €3-4 billion could be saved each year and used (by way of example) for investment in mental health services, youth job-training, emergency social housing.
No fiscal transfer is involved and there is no nominal write-down of debt. In personal example terms, you park most of our mortgage debt while the bank gives no reduction in the amount you owe and no transfer of money occurs between you and other borrowers or lenders.
How long do you have to pay back? That depends on fast your income grows. In the SML proposal the suggestion is to freeze repayments or payments of interest until total debt falls below 20% of GDP. In a simulation of growth used in SML it takes 40 years for Ireland to reach the point where repayments are due. In the case of Italy it is 60 years and in Greece 58 years. These estimates are based on hypothetical cases and technical working assumptions bearing in mind that wide divergences in outcomes are possible.
Chart General Government Debt % of GDP with debt in excess of 50% of GDP bought up by ECB
However, the Working Paper by Sotiropoulos Milios and Lapatsioras is not a purely academic or technical exercise. They write:
‘The critical parameter is thus the mobilization of labor and not the technical sophistication of an abstract solution.’
A long technical footnote
Is debt ‘technically’ sustainable (as distinct from ‘politically’ and ‘socially’ sustainable)? Some calculations based on a very simple-to-use online public debt calculator provided by the Financial Times may be of assistance. It shows that, under very optimistic forecasts of 2-3% real annual growth from 2015 onwards, real interest rates staying at around 3% and with a primary government deficit rate of between 3-5% per annum total public debt, in Greece, would fall from 175% of GDP in 2013 to 145%. That would still be 240% above the EU rule of 60% of GDP. It might take decades before the debt level is brought under 60% under these particular assumptions. Just shift the underlying assumptions so that real GDP growth is zero and interest rates climb to 5% by 2019 while the primary government deficit stays at between 3-5% of GDP each year and you get a rising level of public debt (reaching 180% of GDP in 2019). Either scenario is a no-fun scenario for Greece or, for that matter, Europe. Something has to give. The US and the UK knew this in 1953 and that why West Germany got a massive debt restructuring at the time.
Incidentally you can try the difference scenarios for Ireland’s debt using the same online tool. With real annual GDP growth at 3% per annum, a primary government deficit rising to 4% by 2019 and an effective real interest rate of 3% over time, you observe a fall in debt from 116% in 2013 to 98% in 2019. Welcome and solid but nothing to ‘write home about’. Just shift some of the underlying assumptions and we are in serious debt trouble (think of a hike in interest rates). For example, a slump or stagnation with no growth in GDP and a modest (by historical norms) rise in interest rates would see no reduction in Ireland’s debt as a % of GDP. This might be viewed as very unlikely as of early 2015. However, nothing can be ruled out as the experience of 2008-09 taught us.
The precise calculations behind what economists call ‘debt dynamics’ (how debt changes with changes in underlying conditions on growth, inflation and interest rate costs) are summed up in this equation:
dt = dt − 1 × (1 + rt) ÷ (1 + gt) × ((1 − st − 1) + s t − 1 ÷ (1 + zt)) − pbt
Where:
d=government debt
g=real GDP growth
r=effective real interest rate
pb=primary government balance (deficit net of debt service costs)
z=change in real exchange rate
a=share of public debt in foreign currency (s).