At a lunchtime meeting on 26 March, held to mark the launch of Public Debt Management: Theory and History, Rudiger Dornbusch discussed problems of public debt management in a monetary union. Dornbusch is Ford International Professor of Economics at the Massachusetts Institute of Technology and a Research Fellow in the Centre's International Macroeconomics and International Trade programmes. The meeting took place as part of CEPR's research programme on `Financial and Monetary Integration in Europe', which is supported by the Commission of the European Communities under its SPES programme. The views expressed by Professor Dornbusch were his own, however, and not those of the European Commission nor of CEPR, which takes no institutional policy positions.

Dornbusch noted that the EC member countries' widely differing ratios of public debt to GDP have been cited by some notably Germany as a reason for delaying progress towards economic and monetary union. The linkage between the two issues is in fact rather tenuous, but it provides a useful excuse for inaction by governments that do not wish to proceed further for other reasons. EC public debt is an issue of major concern, however, for four main reasons.

First, Belgium, Greece and Italy announced public debt/GDP ratios for 1990 of 77%, 89% and 90% respectively and the Greek ratio is widely believed to be an underestimate. In contrast, the US public spending deficit has attracted much more attention, with a debt/GDP ratio of only 42%. Rational agents should be reluctant to hold these `high-debt' European countries' bonds, but Latin American experience suggests that agents typically adjust the premiums they require after a default and not before.

Second, Germany previously a model of fiscal rectitude is now running the `mother of all deficits' to cover the cost of transfers to its eastern part through an open-ended commitment to a welfare state. Almost all of this deficit is being raised to finance consumption, and it is too early for investors to be sure that this will be a temporary phenomenon.

Third, the European Community as a whole accounts for a considerable proportion of world public debt, and member governments' policies will therefore exert a major influence on the world interest rates prevailing in the 1990s. It is as yet unclear whether the 1990s will be an era of high interest rates; but investment opportunities in Latin America and the Third World seem more promising than in Europe, and much more promising than in Eastern Europe.

Fourth, negotiations for monetary union are already well under way, and there seems to be general agreement on three main preconditions for the management of such a union's public debt. Monetary accommodation of debt by simply keeping interest rates low should be forbidden; there can be `no bail-out' of member countries' debt by the Community; and there must be no `excessive' deficits. Dornbusch noted, however, that no mechanism analogous to the US Treasury-Fed Accord exists to police the first; that merely to mention a possible bail-out of members' debt invites its serious consideration; and that `excessive' deficits must be defined before they can be prohibited.

Dornbusch maintained that a country with a high public debt contemplating entry into a monetary union can reduce its debt ratio gradually over time by imposing high taxes on all social groups in order to run a fiscal surplus. Although this policy was pursued successfully by Ireland in the 1980s, it would not work in Italy today, which has poor control of its tax system; and burdening a country with taxes is also poor supply- side economics. Alternatively, a country may write off part of its existing debt although it may be more diplomatic to call this a `consolidation' or a `levy'. This seemingly drastic action will enable the government to cut taxation and create a better basis for future economic growth. Such write-offs have been effected historically through extreme inflations and currency collapses, but a deliberate levy could be carefully designed for the write-off to inflict a minimum of disruption to the rest of the economy. In contrast, if an extreme inflation were anticipated by the market, this might exacerbate the problem and increase the adjustment required. Dornbusch argued that imposing a levy is therefore probably the most conservative course of action a government can take, since the punitive taxation required to avert such an apparently extreme step would probably hit most domestic bond-holders harder. Moreover, the intra-EC taxation differentials required for Italy (for example) to reduce its domestic debt by fiscal means could not be sustained so long as the full freedoms of factor mobility dictated by the Community's economic union remain in place.

Dornbusch maintained that once the necessary convergence of debt ratios has been achieved, creating a European `reserve currency' will certainly affect the structure of international bond markets. Nevertheless, this will only affect the Community's external exchange rate which determines international trade flows if national debts are to be `Europeanized' overnight, in which case it remains unclear what will happen to Italy's debt in the mean time. Any Community-wide public debt policy would be constrained for two reasons: an overall deficit will raise world real interest rates, since the Community is a large region; and tax competition among member countries will tend to create deficits for which none of them is willing to pay. EC member countries should learn from the experience of the US, whose member states now maintain representative offices in Tokyo to compete for inward direct investment. In the face of a recession, all member countries will favour public spending to raise demand, but none will be willing to raise its own taxation first to pay for its share of this spending, so the recession may be unnecessarily prolonged.
Dornbusch then turned to the possible sets of rules that a union's member governments might follow. He noted that the `German' rule of `no deficits' imposed on post-war Germany by the Allies admitted an exception in the case of deficits to finance expenditure on investment. Such a rule which the German government would now wish to impose on Italy would be too vulnerable to clever accounting techniques to be enforceable. Such rules should also distinguish between `structural' and `cyclical' deficits: in particular, for a developing region with a large public sector such as Spain or southern Italy the fiscal deficit should be large if convergence with the rest of the Community is to be achieved in the longer term. Dornbusch concluded by suggesting that once the exchange rate instrument has been abandoned as an adjustment mechanism within a union, the remaining necessary adjustments may be better achieved through inter-regional wage flexibility than through fiscal policy coordination.


Rudiger Dornbusch and Mario Draghi (eds.), Public Debt Management: Theory and History, Cambridge University Press for CEPR, £30.00 or $54.50.