As the European debt crisis grinds on, some countries, especially Italy and Spain, have complained that despite having initiated reforms they must pay "unreasonably" high interest rates to finance their national debt. They have asked the European Central Bank (ECB) to buy up their bonds in order to assure a maximum interest rate that is "reasonable". The ECB intends to follow through by purchasing government bonds but without setting an explicit interest rate target as long as the countries in question promise to satisfy certain reform conditions under the European Stability Mechanism (ESM).

The decision of the ECB to finance state debt is economically dangerous and legally questionable. But I would like to address another question here: when, indeed, are interest rates "reasonable” for countries hit hard by a debt crisis? One often hears the argument that the interest rates Italy paid before the introduction of the euro were just as high as now, which is one way of saying that Italy's complaints lack substance. But the matter is not that simple, as anyone who has taken Economics 101 knows.

First of all, a country's budgetary deficit and debt must be placed in relation to GDP. The larger the GDP, the higher the tax revenues - and the easier it is to service debt. It is also necessary to distinguish between interest expenditures and primary expenditures. Primary expenditures go to finance a state's core functions. When the primary budget has a positive balance, revenues exceed primary expenditures, which means they suffice to finance not only primary expenditures but also part of interest expenditures. The primary budget surplus needed to cover all interest expense obviously depends on the interest rate and the amount of government debt. But it also depends on GDP growth.  

The formula that governs the relationship between the primary balance and debt levels can be illustrated with the following example. If a country wants to keep its debt-to-GDP ratio constant, then the ratio of its primary balance to GDP must equal the debt-to-GDP ratio multiplied by the difference between nominal interest rate and nominal economic growth. The debt-to-GDP ratio for Italy is around 120 per cent. If the financial market for Italian bonds demands an interest rate of, say, six per cent and Italy’s economic growth amounts nominally to three per cent, a primary surplus of 3.6 per cent of GDP is necessary for stabilizing the debt-to-GDP ratio. With an interest rate of seven per cent, the primary surplus must total 4.8 per cent of GDP.

But keeping the debt level constant is not enough to satisfy the terms of the Maastricht Treaty. The reformed stability and growth agreement demands that national debt be reduced by one-twentieth every year until the debt-to-GDP ratio falls below 60 per cent. Let’s return to the example of Italy. Given an interest rate of seven per cent and a nominal economic growth rate of three per cent, the German Council of Economic Experts estimates that Italy in the next few years will have to achieve a primary surplus amounting to eight per cent of GDP. With an interest rate of five per cent, the necessary primary surplus would be just under six per cent of Italy’s GDP. Historically, few industrial countries have managed to maintain a primary surplus of more than four per cent of GDP for any extended period.

These estimates show that without lower interest rates in the euro zone, reducing countries’ debt-to-GDP ratios to Maastricht levels will be difficult. Given this fact, if one protests ECB intervention, then one is obliged to highlight alternatives. One possible solution is the European Redemption Pact proposed by the German Council of Economic Experts.

Date

11.10.2012

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