Gross government debt vs government net worth (2013)

Gross general government is the most frequently used indicator in terms of cross-country comparisons. The concepts covers the financial liabilities of the central and sub-national governments. While it takes into account social security funds, it does not include the liabilities of financial or non-financial government-owned enterprises. It also fails to account for government assets. Net general government debt, for instance, nets out the general government’s financial liabilities and assets (with the exception of shares, equity and derivatives). Consolidating the assets and liabilities of both the general government sector and the central bank, one arrives at ”net financial worth of the consolidated government and central bank sector”. One could go further and take into account non-financial assets owned by the government (e.g. buildings, land) to arrive at “net worth.” Last but not least, one could add the assets and liabilities of government-owned companies as well as government equity holdings of partly privatised enterprises into the mix to arrive the broader public sector’s net worth. If nothing else, the broader concepts suggest that in terms of stock (if not necessarily, flows), the financial position of many advanced economy governments are not as bad as the general government debt concept might suggest – especially in the case of Japan.

Monetary power & European monetary integration (2012)

Germany’s economic power allowed it to extend its economic model on the rest of Europe. It is not just Germany, of course. Other countries share German policy preferences, largely creditor nations. Germany’s economic power has been increasing over the past few decades. Today Germany is economically and financially the dominant economy in Europe. As such, its ability to influence the economic policies of other countries and its ability to influence the future evolution of the European macroeconomic policy regime is considerable. 

What are the sources of German economic power? First, Germany is the largest economy. Second, Germany has very strong public finances. Third, the capacity to raise debt is significant. Fourth, Germany runs external surpluses and is a large net foreign creditor. Without German’s financial strength, any bail-out regime will be inadequate. This effectively means that German non-participation dooms any bail-out regime. If, for example, Finland decided not to contribute to a financial rescue, it would not significant diminish the regime. That said, rising trade and financial integration has also made Germany both more sensitive and vulnerable. Economic-financial interdependence often is asymmetric and this asymmetry provides Germany with a great deal of influence in European economic and financial affairs. 

The (West) German economy has been characterized by a specific combination of institutions, ideology and interests, creating a German model of macroeconomic management. The combination of these institutions somewhat inadvertently led to the rise of Germany structural power (Strange). In a way, Germany obtained economic power as inadvertently as some people say Britain acquired its empire: in a fit of absent-mindedness.

What institutions underpin the German model? First, the West German government established an independent central bank tasked with maintaining low inflation. (This was largely the result of the experience with hyperinflation in the 1920s.) By contrast, central banks in other major West European countries were not as independent or not independent at all. Germany was able to establish a track record of monetary stability and maintain inflation rates at levels consistently below those of the other major European economies, such as France, Italy and the UK. 

Second, the government made far more modest use of an activist fiscal policy to support economic growth. Keynesianism experienced only a very short-lived popularity in the late 60s and early 70s. Ultimately, it was the priority accorded to price stability rather than growth and an independent central bank unwilling to accommodate expansionary fiscal policies that put paid to activist fiscal policies. A relatively high degree of economic openness also limited the effectiveness of fiscal stimulus measures. Last but not least, German ordo-liberal thinking dominated economic policy. More speculatively, Germany, aware of its precarious position as a frontline state, was also more concerned about high public debt than other European countries.

Third, the structure of the German wage bargaining system, dominated by unions in the export sector, typically resulted in wage moderation. Thus export openness contributed to relatively lower wage inflation (adjusted for productivity) than in other countries where wage bargaining was dominated by unions operating in sheltered sectors, including public services, or more militant unions, period. An independent central bank whose actions would have helped increase unemployment rather than accommodate inflationary wage settlements was important. The wage bargaining ha undergone important changes since the nineties, but it remains geared to preserving German economic competitiveness.

These institutional features created a macroeconomic policy regime that prioritized low inflation over economic growth and ended up relying on exports for economic growth rather than activist and potentially debt-increasing fiscal policies. Not only did this allow Germany to establish a track record of monetary and fiscal probity. It also contributed to structural trade and current account surpluses throughout much of the post-war period. The commitment to financial stability and external surpluses increased German power as Europe became economically and financially more integrated. This became increasingly evident following the break-up of the Bretton Woods system and the creation of (various) European exchange rate regimes.

In the context of balance-of-payments imbalances, power derives from the “capacity to avoid the burden of adjustment required by payments imbalance” (Cohen 2006: chapter 2). This provides the surplus country with autonomy and constrains the policy space of the deficit country. While the surplus country is autonomous, the deficit country will sooner or later be forced to either devalue (so-called expenditure-switching policies) or adjust monetary and fiscal policies (expenditure-changing policies) to address the external disequilibrium. The external equilibrium needs to be restored via decreased domestic absorption and increased exports. 

The autonomy of the surplus country is reflected in its greater power to delay and deflect economic adjustment. If the deficit country does not adjust, it will eventually run out of reserves, as the markets will become unwilling to finance the deficit. The surplus country, by contrast, is able to hold out much longer by absorbing balance-of-payments surpluses in to FX reserves. This may or may not have economic consequences somewhere down the line (e.g. inflation). But it is clear that, unlike the deficit country, the surplus country can choose to resist nominal exchange rate appreciation more easily and is less readily forced to adjust its macroeconomic policy mix. In general, the surplus country finding it easier to both delay and deflect adjustment is able to stick to its macroeconomic preferences, while the deficit country is not. 

It is useful to distinguish between the permanent costs of adjustment and the transitional costs. The transitional costs associated with a change in economic policy typically falls on the deficit country. The permanent economic costs in terms of output and domestic consumption are always shared, even though they are typically felt much more strongly in the deficit country. After all, the deficit country needs to reduce domestic absorption and export more, while the surplus country (in a two-country model, at least) will need to increase domestic absorption and reduce exports, if balance is to be restored. Put differently, a devaluation of the deficit currency will lead to the revaluation of the surplus currency. The question hence is which country will adjust its economic policies and sacrifice or compromise its macroeconomic policy preferences. For instance, will the deficit country forego growth in the interest of monetary and fiscal discipline, or will the surplus compromise its monetary and fiscal discipline in order to help restore the external equilibrium.

This analysis becomes especially relevant in the context of fixed (but adjustable) exchange rate and particularly in the presence of an open capital account. There the so-called ‘unholy trinity’ emerges. In this context, the ability of the deficit countries to pursue an independent monetary and, to some extent, fiscal policy is heavily constrained. The country that benefits from the largest current account surpluses, the largest government debt market and the greatest financial credibility will tend to be the only country capable of pursuing an independent monetary and fiscal policy. Even the lesser surplus countries often find their policies constrained the so-called anchor country. If the capital account is closed, countries enjoy (short-term) policy flexibility, even if expansionary policies will ultimately result in devaluation. If the capital account is completely open, even short-term policy flexibility does not exist if the exchange rate peg is to be maintained. 

Source: Economist

Again, this does not mean that the stronger country is an invulnerable position in terms of the permanent adjustment costs. It simply puts it into a relatively less vulnerable position. For instance, a massive currency devaluation of a deficit country will lead to greater economic turmoil there in the surplus country that will see its currency appreciate, not least because the economy of the devaluing currency is only one among many trading partners of the surplus economy.

The emergence of a fixed exchange rate regime in the 1970s and an increasingly open capital account regime in the 1980s in Europe led to the emergence of the deutschmark as the anchor currency in Europe. It increased the constraints on economic policies other countries were able to pursue. This provided Germany with structural power vis-à-vis other European countries. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate (Strange 1996). 

This type of power is not relational, however, in the sense that while it constrains it does not lend itself as a tool to exercise direct influence on another actor’s behaviour. Structural power  (Susan Strange) confers broad policy autonomy, but it does provide the anchor county with direct leverage of other countries’ economic policies. Ultimately, countries not willing to be constrained in this way could always opt to float their currencies, typically at manageable economic - but not necessarily political - costs. Last but not least, structural power does not translate into readily quantifiable, tangibly economic gains, either. It simply means that the structurally dominant country can pursue its preferred economic policy, while indirectly and inadvertently forcing others to adjust their policies.

Famously, this type of power was put into relief during the early 1990s. Reunification had led to a rising demand and price pressures in the German economy, leading the Bundesbank to raise interest rates. However, other ERM countries were cyclically in a very different position. In the face of ‘speculative’ attacks, a number of countries were forced to devalue. This demonstrates neatly the structural nature of German power. German policy-makers, unlike others, enjoyed policy autonomy. By taking advantage of this autonomy, they set the constraints under which other policy-makers had to operate. By contrast, the other countries saw their own policy space heavily constrained.

The advent of EMU and actually one of the reasons why EMU came into existence was because the deficit countries were eager to remove the balance-of-payments constrained and thus diminish German power by supra-nationalising monetary policy. In the context of a monetary union (read: irrevocably fixed exchange rates), balance-of-payments deficits will always be financed by the private- or, failing this, by the official sector. On the flipside, the fiscal constraint becomes tighter for financially/ fiscally weaker countries. Fiscal problems cannot easily be addressed by way of a growth-boosting devaluation. The lack of control over monetary policy removes a further tool to address fiscal imbalances, at least in the short term. Put differently, monetary union removes expenditure-switching (read: devaluation) as a policy option and leaves weaker countries only with expenditure-changing policies (read: fiscal austerity).

The move from fixed (but adjustable) exchange rates to monetary union helped enhance the power of the economically stronger country in similar way the move from a closed to a an open capital account in the context of a fixed exchange rate regime strengthened the power of the surplus country. Similar to balance-of-payments imbalances, large fiscal deficits and/ or rapidly rising debt weaken the policy autonomy of the financially weak country. The fiscally stronger country, enjoying superior access to market funding at cheaper rates, enjoys far greater policy autonomy. Similarly, the ability of the fiscally weaker country to defer or deflect adjustment compared with the country with sound public finances is much weaker. The strong country can choose to maintain fiscal discipline or it can decide to pursue expansionary policies, thus supporting the short-term adjustment of the fiscally weaker countries via higher growth. However, not facing immediate market pressure to adjust policies, it is in a position to delay and deflect adjustment. The financial weak country is not. 

Again, adjustment is always mutual, complementary and shared in the sense of the eventual economic costs. They are also typically much larger in the case of the weaker country. The question is once more who will bear the transitional costs in terms of adjusting fiscal policies. Will the fiscally stronger country boost domestic demand and, especially in the context of fixed rather than flexible exchange rate, help boost economic growth in fiscal weaker country, thus supporting adjustment there. Or the will the fiscally weaker country be forced into fiscal retrenchment, potentially leading to a decline in economic growth and a further deterioration of the fiscal position. To a significant degree, this is a question of whose policy preferences will prevail and which country will absorb the ‘transitional costs of the adjustment’. 

The fiscally and financially stronger country is not invulnerable. Fiscal austerity will reduce export growth and, more extreme, a sovereign default would typically lead to financial losses in the fiscally stronger country to the extent that it holds claims. Potential financial contagion could further raise the economic and financial costs. However, the costs to the defaulting country will almost always by far exceed the costs incurred by the financially stronger country. The stronger country may not be invulnerable, but its relative stronger position confers its significant leverage vis-à-vis financially weaker governments by way of the provision of conditional financing. This leverage does lend itself more easily to the exercise of relational power, that is, the power get another state to take actions it would otherwise not have taken.

The sources of German financial and ultimately relational power are similar to the sources of structural power in the case of balance-of-payments imbalances. In addition to running external surpluses and having established a solid monetary and financial track record, other factors matter.

First, Germany is among the larger European economies the one with greatest borrowing and lending capacity. This is currently reflected in lower debt ratios, a lower fiscal deficit, an AAA credit rating and, most revealingly, in low yields on government debt. The combination of economic size and borrowing capacity makes Germany the most powerful country in terms of its ability to extend credit to other countries in financial need.

Second, Germany is constitutionally obliged to run a structural surplus (so-called ‘debt brake’). This provides investors with some assurance that government finances will remain on a sustainable path. Moreover, from a more short-term perspective, Germany’s short- and medium-term fiscal outlook will not force it to implement growth-diminishing fiscal austerity. It also has a greater capacity to generate economic growth through extra-EMU exports, offsetting weaker intra-EMU exports, than most other European economies. 

Third, German debt is a ‘safe haven’ asset for EUR investors in the context of monetary union. Due to its track record of monetary and financial stability as well as its large current account surpluses, investors are willing to lend to Germany in times of market stress, typically at very favourable conditions. This has thus far led to an easing of Germany financing conditions, further underlining its continued ‘anchor’ economy function in the context of EMU.

In short, the Germany benefits from the largest borrowing capacity and the most favourable interest rates. The resulting ability to offer financial support to other governments, bilaterally or multilaterally, provides it with political leverage. Due to its ability to offer conditional financial support in exchange for a change in policy, Germany is the most powerful country in Europe as far as economic policy is concerned. EMU has enhanced not only enhanced German power by narrowing the policy and especially fiscal policy space of the other European countries relative to Germany. Naturally, this is not necessarily a permanent feature of EMU. Germany’s strength is to some extent the function of lack of fiscal discipline and/ or prudence in other countries. EMU has also led to a qualitative change. Power is (much more) relational today, as opposed to (primarily) structural pre-EMU. Germany certainly is not in a position to single-handedly bail out the rest of the Eurozone governments, but its participation in any rescue effort is indispensable if it is to be credible.

Is Germany a regional hegemon? According to Keohane (1986), the hegemon “must have access to crucial raw materials, control major source of capital, maintain a large market for imports, and hold comparative advantages in good with high value added, yielding relatively high wages and profits”. This definition is somewhat expansive. A weaker version requires the hegemonic state to be “powerful enough to maintain the essential rules governing interstate relations, and willing to do so” rather than “structural domination”. Germany does have access to raw materials, even though this access is taking place on a commercial rather than a political or jurisdictional basis. Depending on how narrowly one defines this characteristic, Germany may or may not meet it. It does however meet all the other criteria. Germany is undoubtedly the largest provider of capital in Europe. Its current account surplus (equivalent to net capital flows) is running at around 4-5% of GDP (or EUR 200 bn). It is also the largest producer of capital goods. Not only is Germany the largest economy in EMU, it is also the largest market of intra-EMU imports, accounting. Last but not least, it does hold a comparative advantage in terms of high value added goods and both wages are high and corporate sector is very profitable.

This definition of hegemony may be a somewhat arbitrary definition. Ultimately, it may be more interesting to analyse how, where and to what effect German economic power historically manifested itself. In economic terms, the breakdown of the Bretton Woods system left Germany’s macroeconomic preferences unchanged, while its own macroeconomic policies in the context of fixed exchange rate and increasing cross-border capital flows created increasing constraints for others. Germany’s power was largely structural in nature. While Germany had a strong preference for stabilizing intra-European exchange rate in order to maintain financial stability and export competitiveness, its ability to change other countries economic policy mix was very limited. Indirectly, however, structural power contributed to the decision of other countries to agree to so-called convergence policies and a German-style monetary union. 

European monetary integration has increased German power, but has also increased its vulnerability. EMU may or may not have been a quid pro quo for German reunification. But EMU almost completely reflected German policy preferences and effectively led to the extension of Germany’s monetary regime to the rest of Europe. EMU ended up increasing Germany’s relative power (as well as its absolute economic-financial vulnerability). Rising market pressures punished fiscally weaker countries, while enhancing the political power of the fiscally stronger countries, namely Germany. Germany’s ability to successfully operate under the constraints imposed by EMU (low inflation, no competitive devaluation, generation of growth via exports) combined with a domestically institutionalised preference for fiscal discipline allowed Germany to out-compete most other countries and maintain sound public finances. This ended up conferring relational power, defined as getting somebody to do something s/he would not otherwise have done. Not only does the newly emerging Eurozone governance structure, including the initial rescue efforts, reflect German preferences. 

Government debt in the advanced economies with special reference to Japan (2013)

Japan is the country with the highest level of government debt among the advanced economies. Continued large fiscal deficits will push the debt-to-GDP ratio to more than 250% of GDP by the middle of the present decade. Japan’s position is nonetheless not as dramatic as it looks. (1) In net terms (net of government financial assets), debt stands at 135% of GDP. This is still high, but not unprecedentedly so. (2) Government debt in Japan, unlike in the other advanced economies, is not consolidated on an intra-government basis. Intra-government consolidation would reduce the net debt ratio by another 20 percentage points or so. (3) If non-financial assets are taken into account (e.g. fixed assets, land), the government’s net worth is roughly zero. (4) Furthermore, if the government balance sheet is consolidated with the central bank and the broader public-sector, public sector net worth looks even more favourable. (5) Japanese government debt is predominantly owned by residents, predominantly banks. Government moral suasion makes it unlikely that they will refuse to finance the government. (6) Contingent liabilities in terms of future pension- health-related spending are comparatively low in Japan, in spite of relatively adverse demographic trends. (7) Last but not least, Japan is the world’s largest international creditor. Admittedly, if the government fails to significantly reduce the fiscal deficit of 9% of GDP (on a cyclically adjusted basis), government debt will become unsustainable over the medium- to long-term. Nonetheless: the Japanese government’s present financial stock position is not as dire as the headline figures might suggest.

Source: IMF

The political economy of structural reform in the BRIC (2013)

The BRIC economies, like most other economies in the world, experienced a slowdown in 2011-12. The bears are worrying that this slowdown might contain a significant structural component. These concerns seem somewhat overdone. Sure, the last decade saw strong global economic growth against a backdrop of low interest rates, increasing global trade flows, rising capital flows to emerging markets and rising commodity prices (the latter benefitting countries like Brazil and Russia). The global growth outlook for the next few years is more modest by comparison.

China is indeed unlikely to return to double-digit annual growth rates, not least because the authorities believe that 7-8% growth is sufficient to maintain political stability. Brazil continues to experience sub-par growth. Indian and Russian economic growth has also decelerated to multi-year-ex-2008/09 lows. The IMF has just revised its 2013 growth forecast to 3.4% and 5.7% for Russia and India, respectively, and 3% for Brazil.

Source: IMF

The growth potential of the BRIC economies nonetheless remains sizeable. All BRIC countries benefit from plenty of catch-up potential and scope to raise productivity via an increase in the physical and human capital stock. The first reason for optimism is that savings have not declined materially, and may even rise over the medium term. The current account positions are strong (China, Russia) or quite manageable (Brazil, India). This means that an acceleration of investment won’t be much constrained by a lack of savings.

Most importantly, the BRIC countries are economically well-positioned to unlock their growth potential through structural reform. Brazil and India, for instance, have taken a number of structural measures recently (e.g. greater FDI in India, infrastructure concession sales in Brazil) Rather than solely relying on anti-cyclical demand-oriented macro policies à la 2008/09, they seem to have been spurred into pursuing structural reform aimed at enhancing productivity and international competitiveness by concerns that the current slowdown might be more structural than cyclical. Admittedly, none of these reforms qualify as big-bang reforms; but they should, at the margin, help support growth over the medium term. Encouragingly, these measures reflect the authorities’ recognition that supply-side reforms are at least as necessary as demand-side policies if high growth is to be sustained over the longer term. Rising inflation in both countries has undoubtedly helped focus policy-makers’ minds.

China has thus far largely refrained from taking strong anti-cyclical policy measures as well as from pushing major structural reforms. This is largely explained by the leadership transition as well as concerns about the longer-term potential negative consequences another large policy stimulus might have for existing economic imbalances. Technocratic-minded groups have put forward a blueprint for further financial sector reform and analysts expect a number of other measures to be forthcoming under the new government (e.g. social housing, infrastructure). The recent publication of a plan to raise household income shows that the authorities are aware of the need to tweak the growth model. Russia is looking at a number of reforms following last year’s presidential elections; though, it remains to be seen how serious the new government is about reform. Importantly, the Russian government seeks to privatise USD 45 bn worth of public sector assets in 2013-15 and to increase infrastructure investment, especially in the Far East.

Recent Brazilian and Indian reforms may appear somewhat surprising. After all, the political-institutional backdrop for reform appears relatively unfavourable – more so in India than in Brazil. PM Singh’s government has been struggling for a long time to persuade its unruly parliamentary coalition to back reforms. The opposition BJP, though in principle more inclined toward reform, has proven less accommodative of reforms than might have been expected. Aggressive reforms carry the risk of destabilising the parliamentary coalition government. This is one of the main reasons why India has not seen more extensive reforms over and above the measures alluded to above.

In Brazil’s presidential political system, unlike in India, the executive does not depend on its congressional base for survival; but the president similarly needs to rally support in a highly fragmented congressional base and multiparty presidential coalitions in order to implement more wide-ranging reforms. The government has had at least one major success (e.g. public sector pension reform). It has also taken a number of other measures aimed at reviving economic growth (e.g. tax cuts, lowering of electricity tariffs). These latter measures did not require the president to spend lots of political capital or build large coalitions in congress, which perhaps explains why they were passed easily.

In institutional terms, the Chinese and Russian governments are better positioned to implement structural reform than Brazil and India, at least as far as the surmounting of legislative obstacles and societal opposition is concerned. In Russia, the presidency has not only extensive powers, but it currently also enjoys a majority in the Duma. In China, the executive rules supreme, even if it often has to contend with different technocratic and regional factions as well as well-connected vested interests, before a sufficiently large consensus on reform policies can be reached. In this respect, it is crucial that Chinese governments (or leadership groups) typically stay in power for a whole decade.

This latter fact is significant because it affects the incentives to pursue structural reform. This is critical, for the economic – and political - benefits stemming from structural reform typically materialise only over time, while the political and electoral (or legitimacy) costs typically materialise instantly. The OECD in a recent study finds that the full pay-off from structural reforms takes on average five years to materialise. This coincides almost exactly with the electoral cycle in democracies. It is easy to see why, unless a country is facing a severe crisis – like India in 1991, Russia in 1997 and Brazil in the early nineties – big-ticket reforms are rather uncommon. If they do take place, they almost inevitably take place early on in a government’s term and, not infrequently, get watered down by vested interests or blocked entirely by so-called ‘veto players’. Given how concentrated the costs of, and how dispersed the benefits from, reforms are (aka higher medium-term growth), vested interest find it relatively easy to mobilise against reform relative to the ‘silent majority’, who would benefit relatively less than vested interests.

A moderate, gradual slowdown in economic growth is harder to instrumentalise in terms of mobilising political support for structural reform – as opposed to an outright economic or financial crisis. This is why the reforms in Brazil and India may look somewhat surprising – then again, the reforms that were passed are not exactly the type of high-impact, growth-accelerating reforms that are needed to raise economic growth dramatically. In purely political-institutional terms, China and, somewhat less so, Russia would appear to be far better positioned to pursue medium-term growth-enhancing reform than Brazil and India – at least once the government makes up its mind.

The long and short of it is this: if the growth decline in the BRIC economies were to prove more pronounced than we currently anticipate and reveal itself to be more structural than we believe, we would expect greater reform efforts to come through, especially in China and Russia. The relative lack of reform in China and Russia was likely due to the perception that economic growth remains broadly satisfactory. (This perception is changing fast in Russia at the moment.) It is encouraging that the Brazilian and Indian governments have taken structural measures – however modest in the eyes of critics – aimed at raising the medium-term growth potential, instead of solely relying on politically less costly demand side measures (though Brazil at least has done this, too). The current sense of pessimism pervading analysts’ views of the BRIC therefore appears overdone. None of this is meant to suggest that structural reforms will be politically easy. The good news is that at least there is a, albeit varying, degree of recognition among the BRIC governments that such reforms are necessary. Once committed to reform, China and Russia will have an easier time implementing them than Brazil and India.