In focus

Fiscal Policy.

Almost every country runs up debt. What matters is whether the markets believe it will be repaid. But cutting spending to keep that trust often costs governments votes at the ballot box.

Spending more than you have

Fiscal policy means managing a government’s revenue and spending, and with them its debt. Government debt is nothing new. Apart from a handful of countries such as Liechtenstein or Macao, every country is in debt. That is not unusual: individuals and companies also take out loans for larger investments and pay them back. But while individuals have to repay their debts or risk insolvency, a government has more room for manoeuvre: its debt is passed on from one generation to the next. What matters is that the financial markets trust the money will be repaid. That is exactly where it gets difficult.

Government spending has been rising for years, especially in the Western industrialised countries. One major reason is the rising cost of the welfare system, for example pensions, healthcare or minimum income support. At the same time, investment is needed in the transformation of the economy, infrastructure, digitalisation, renewable energy and education. In many European countries, defence is on the list as well. That means spending has to be cut elsewhere, so that the Maastricht criteria (new borrowing of at most 3%, total debt of at most 60% of nominal GDP) can at least somehow be met.

The rules: Maastricht and the markets

The Maastricht criteria were set ahead of the introduction of the euro to keep the common currency stable. If a country’s debt is too high, its currency would normally depreciate, which is not possible within a common currency. Critics keep asking whether the limits are set at the right level. They are not laws of nature, and the sanctions for breaches have never actually been enforced. So what is the point of sticking to them? A country that overshoots by a wide margin and is also stuck in political deadlock risks raising doubts about repayment. Risk premiums on the financial markets then rise, interest rates shoot up, and servicing the debt becomes even more expensive.

There is no fixed threshold beyond which a country can no longer repay its debt. What matters is when the markets lose confidence: the rating falls, the debt can no longer be refinanced, and the country defaults. The International Monetary Fund (IMF) then often has to step in, usually with strict austerity conditions.

Cutting spending costs votes

Cutting spending or raising revenue leaves some people with less money. Those people are also voters. Unpopular fiscal decisions are therefore often punished at the ballot box, and in extreme cases they even lead to unrest on the streets. The positive effects of austerity, by contrast, only show after several quarters, sometimes only after years. By then, the political agenda has long moved on. Responsible action is therefore rarely rewarded straight away, and fiscal policy remains an unpopular topic.

What matters

Whether debt becomes a problem depends on three things. First, what the money is spent on: investment in long-term projects is necessary, because a country that does not invest, like a company that does not, falls behind. Second, the framework: especially in a crisis such as the Covid pandemic, extra spending is needed, but it requires strict rules, because any loophole invites abuse. Third, whether the financial markets trust the country: without that trust, things get uncomfortable. Fiscal policy is therefore the art of balancing investment, rules and trust.

Quick questions

What is the difference between a deficit and government debt?

A deficit means that a government spends more in a year than it collects in revenue. If it spends less, there is a surplus. Germany has had those in the past, too. Government debt is the sum of all past deficits and surpluses: it rises with a deficit and falls with a surplus. As a share of GDP (the debt-to-GDP ratio), however, debt can stay stable or even fall despite a deficit, as long as the economy grows fast enough.

Is government debt a problem in principle?

No. A country does not have to repay its debt in full. As long as it can replace maturing bonds with new ones, and the markets consider the debt sustainable relative to economic output, there is no problem. A default only happens when creditors stop rolling over maturing debt.

When does government debt become a problem?

A problem arises when debt becomes too high relative to economic output, or when the markets lose confidence that politicians will get the debt under control, for example because of political deadlock. Investors then demand higher risk premiums. There is no fixed threshold, and debt is usually judged relative to economic output. The US is an exception: for historical reasons, it still has a fixed debt ceiling, which has to be raised again and again.

What role do the Maastricht criteria play, and what happens if they are breached?

The Maastricht criteria limit new borrowing to a maximum of 3% and total debt to 60% of nominal GDP. Their aim is to keep the common currency stable. Exceeding the limits does not automatically have consequences: in the case of a serious breach, the EU opens an excessive deficit procedure, which calls on the country to take countermeasures. Sanctions, however, have never actually been enforced.

How does inflation affect government debt?

New borrowing and total debt are measured relative to nominal GDP. When prices rise, nominal GDP grows and the debt ratio falls, even though the debt itself has not changed: the government repays the same amount later, but it is worth less. This only helps as long as interest rates do not rise at the same time and spending such as pensions and salaries does not grow at the same pace. Inflation is therefore no lasting way out of debt.

When do extra spending and government investment make sense?

Investment in infrastructure, education, digitalisation or energy is needed on an ongoing basis to maintain a country’s economic output. Extra spending can be necessary in crises to support the economy and preserve social peace, for example after unforeseeable external shocks such as the Covid pandemic. Both only make sense with clear rules: limited in time, targeted and within tight guardrails.

Fiscal Policy