1.
[Book excerpt]
ECONOMIC POLICY: THEORY AND PRACTICE (Oxford UP, 2010)
By Agnès Bénassy-Quéré, Benoît Coeuré, Pierre Jacquet, and Jean Pisani-Ferry
Pp. 195-96
3.2.2 Public debt sustainability
Our analysis so far has focused on flows -- receipts, expenditure, and deficits. But flows result in stock accumulation, meaning that deficits give rise to debt. Debt, in turn, needs to be serviced, which impacts on deficits. We therefore need to look into the public debt accumulation issue.
a) Solvency
Ricardian equivalence theory emphasizes the government intertemporal budget constraint, which sooner or later calls for raising taxes when spending has increased. Borrowing is only deferring charges to the future. Unlike households, however, governments consider themselves to have an infinite lifetime, [Note 25: There are examples of states that wind up and close their books, but legacy debt is then carried over to newly established countries. For instance, Czechoslovakian debt was split between the Czech Republic and Slovakia on 1 January 1993. There are also examples of governments that refuse to pay for their predecessors' debt because they deem it politically illegitimate. This famously happened after the Russian and Chinese revolutions. It was actually proposed, as a form of sanction, to formally declare debts incurred by illegitimate dictatorship odious debt, meaning that successor governments have a right to repudiate it (Kermer and Jayachandran, 2002). But since political regime change cannot usually be foreseen, it is difficult to integrate it into ex ante sustainability analysis.] so their debt never requires to be redeemed. To be more precise, expiring debt will be paid off through new borrowing, because it is reasonable to think that future generations will be willing, when their turn comes, to use part of their savings to acquire government securities. Is there no limit to the state's borrowing capacity? Asking this question amounts to assessing the state's solvency (i.e. the availability of resources allowing it to meet its commitments.
It is relatively easy to determine when a household or a private firm is insolvent but the same does not hold for a government. At first sight, the capacity of a state to ensure the service of its debt could appear unlimited, since it has the power to raise taxes or, if the central bank is not independent, monetize the deficit (which is the equivalent to a tax since induced inflation reduces the purchasing power of households). However, even before capacity to pay is exhausted, the political limits of the willingness to pay can be reached. As illustrated by many historical episodes, from Ancien Régime crises to Argentina’s bankruptcy in 2002, bankruptcy occurs when citizens no longer accept a further reduction of their income to the profit of the creditors of the state. This is why evaluating the solvency of a state and devising adjustment programs are daring exercises. A senior official for the IMF, John Boorman, expressed it as follows: “Debt can almost always be serviced in some abstract sense, through additional taxation and through the diversion of yet more domestic production to export to generate the revenue and foreign exchange needed to service the debt. But there is a political and social, and perhaps moral, threshold beyond which policies to force these results become unacceptable” (J. Boorman [2002]).
Another difference between a state and a private borrower is that there is no collateral for sovereign debt. If a state defaults on its commitments, neither domestic nor foreign creditors can seize its assets (unless the latter invade the country). [Note 26: To be more precise, they can seize some of its foreign assets but those generally amount ot a small fraction of liabilities.] An indebted state’s attitude toward its creditors depends on the benefits and costs of defaulting on its debt. The benefits result from writing off the debt and the corresponding interest burden, while the costs are mainly reputational: A defaulting state may be cut off from financial markets or at least pay a higher risk premium in the future. History however shows that defaults are frequent, and that especially in recent times, states rather quickly regain access to financial markets (Reinhart and Rogoff, 2008). Unlike for private creditors, assessing the solvency of a state requires an evaluation of its willingness to pay.
If resources exist but cannot be mobilized immediately (one can thnk of forthcoming fiscal receipts or of state-owned companies that cannot be sold immediately due to lack of purchasers), or if they are available but can dry up at short notice (such as short-term credit lines extended by foreign banks), there is a risk that the government defaults even though it is solvent: This is a liquidity crisis. [Note 27: See section 2 of chapter 4 for a theoretical discussion of liquidity in the case of banks.]
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