During the 1980s Greece's external debt rose from $5.1 billion to $20.6 billion (from 13% to 40% of GNP), debt servicing more than tripled as a percentage of current receipts from abroad, and inflation rose from an average of 12.3% in the 1970s to 19.6% over the subsequent decade. Public debt rose from 27.4% to 91.5% of GDP, and government expenditure from 17% to 49.4% of GDP, in 1979-88.

In Discussion Paper No. 468, Research Fellow George Alogoskoufis and Nicos Christodoulakis use a model of optimal private savings with forward-looking households to assess policies to stabilize the ratio of external debt to GDP. This model recognizes the role of intertemporal private-sector responses to fiscal policy, which traditional Keynesian models ignore. A forward-looking private sector will stabilize the ratio of its own total assets to GDP through its consumption pattern, so stabilizing the public debt/GDP ratio should also stabilize that of the external debt. Alogoskoufis and Christodoulakis argue that a country with a rising ratio of public debt to GDP can stabilize it at its current level in three ways: reducing public expenditure on goods and services; increasing tax receipts; and increasing revenues from money creation, or `seigniorage', to substitute money finance for debt finance.

Stabilization of public debt through increased taxation leads to a higher external debt/GDP ratio than stabilization through reduced public expenditure: higher taxation reduces disposable income, private consumption and real household assets. For a given stock of government bonds, this requires a corresponding reduction in other assets, such as money and foreign assets. Stabilization through increased seigniorage leads to lower external debt than stabilization through increased taxation, since increased steady-state seigniorage revenue raises expected inflation and nominal interest rates and reduces real money balances, so the reduction in private holdings of foreign assets is correspondingly smaller.

They calibrate their model for Greece to estimate the changes required to stabilize public debt at its 1989 level of approximately 100% of GDP. They find that Greece cannot increase its seigniorage revenue, since the 1989-90 inflation rate of 20% already slightly exceeds the seigniorage-maximizing rate. To stabilize public debt at 100% of GDP, the government would have to reduce the `primary' fiscal deficit (excluding interest payments) by some 5 percentage points of GDP per annum more than the new government envisages. Further, Greek membership of the ERM would require a steady-state inflation rate of approximately 5%, with the result that stabilizing public and external debt would then require a primary surplus of 0.6% of GDP. The resulting loss of seigniorage revenue would therefore require a further reduction in the primary deficit of about one percentage point, which seems a small price for the credibility and other gains associated with increased stability of monetary and exchange rate policies.

Fiscal Deficits, Seigniorage and External Debt: The Case of Greece
George S Alogoskoufis and Nicos Christodoulakis

Discussion Paper No. 468, September 1990 (IM)