A number of economists are proposing a more expansionary fiscal policy based on debt financing, most noteworthy Olivier Blanchard in his presidential address at the ASSA meeting 2019 (Blanchard (2019). The central argument is that the currently low yields on government bonds, lower than economic growth, make it attractive to borrow and spend. It is almost a free lunch. Growing inequality, wage stagnation, austerity fatigue, and rising populism are other arguments for increased government spending. Secular stagnation and a monetary policy that has hit the zero lower bound serve as additional reasons for fiscal policy assuming a greater role in stabilising the economy (e.g. Furman and Summers 2019).
Expansionary fiscal policy relying on debt financing beyond the traditional scope of business cycle stabilisation would be a radical break from the present fiscal philosophy that emphasises fiscal stability through deficit and debt rules, independent fiscal policy councils, and other types of institutional restrictions on the discretionary powers of governments.
Based on the Swedish experience, we propose an alternative perspective on the present debate. For about a quarter of a century, Sweden has followed strict fiscal rules, cut government debt almost in half, relied on automatic stabilisers and monetary policy to stabilise the economy over the business cycle, and used supply side reforms to produce long-term economic growth. The outcome has been a relatively solid growth performance and sustainable public finances. In fact, the present public debate concerns how far debt consolidation should be carried.
In our view, the present push for fiscal activism is short-sighted.1 It has been tried before and failed. Discretionary fiscal policy has a role to play in stabilising the economy but only during major economic crises such as a deep financial crisis. Instead, governments should stabilise the debt-ratio in normal times at a level that allows for ample borrowing and spending if and only if the economy suffers from a major crisis. Slow-growing economies should be subject to supply-side reforms enhancing productivity. Sweden offers a clear example that this is a way forward, counter to recent proposals of deficit financed fiscal expansionism.
The Swedish case of restrictive fiscal policy
Fiscal policy in Sweden during the last half of a century can be divided into two periods. The first period is marked by spending policies inspired by the then prevailing Keynesian view aimed at reviving a stagnating economy. Government debt increased sharply in the 1970s and 1980s. However, economic activity did not improve on average.
The second period starts with the deep financial crisis in the early 1990s with budget deficits in excess of 10% of GDP. The crisis contributed to a complete re-thinking concerning economic policies. A fiscal framework was established to reduce debt. Monetary policy was given the prime role in stabilising the economy in the short run. A number of supply-side measures were introduced to improve economic growth.
The new policy approach was successful (Andersson and Jonung 2019). As demonstrated by Figure 1, Swedish debt went from being one of the highest in Europe to one of the lowest from 1998 to 2017. The debt ratio was 40% in 2017. In the same period, in the euro area the debt ratio increased to 87% and in France to almost 100%. In Germany the debt ratio is 64%, almost back at the same level as in 1995. The debt ratio in the US is presently close to 100% of GDP and on a rising trend.
Figure 1 The debt-to-GDP ratio for Sweden, the euro area, Germany, France, and the US, 1995-2017
Presently, the Swedish fiscal framework consists of five main components: an expenditure ceiling, a surplus target for the entire public sector, a fiscal policy council, a debt anchor, and a balanced budget requirement for local governments. The surplus target is set at one third of a percent of GDP over the business cycle for the general government (central and local government, and the public pension system). Debt is anchored at 35% of GDP +/- 5 percentage points.2
Has the Swedish fiscal consolidation hurt economic growth? Our answer is no. Swedish growth performance has been similar or even better compared to the US and Germany, as seen from Figure 2, which displays the Swedish growth rate in relation to growth in the US and Germany. Growth was lower in Sweden in the early 1990s during the Swedish financial crisis of 1991-93. From 1995 to 1999 government spending was cut drastically combined with increased taxation, bringing about a fall in the debt ratio. Swedish growth was slightly below US growth during this period but above German growth. From 1998 and onwards, Swedish growth has been in line with US growth on average (0.3 percentage points higher), and well above German growth on average (1 percentage point on average) despite the surplus target and a falling government debt ratio during this period. In terms of labour productivity (i.e. GDP per hour worked), Swedish growth has been as high as US growth and half a percentage point higher per year on average compared to Germany.
Long-run growth depends primarily on supply-side factors – not on demand factors. It is true that the flexible exchange rate for the Swedish currency introduced in 1992 has fostered the recovery from the crisis of the early 1990s. However, Swedish growth has benefitted mostly from supply-side reforms. Tax rates have been lowered, the labour market partially de-regulated, the public sector has been made more efficient by ending public monopolies and allowing private companies to run public services. Here the Swedish example runs contrary to the Japanese approach focused on deficit-spending and a rapidly increasing debt ratio. Despite ballooning debt, Japanese growth has been modest even when we take the declining population into account. Japanese labour productivity growth since the late 1990s is well below growth in both Sweden and the US.
Figure 2 Swedish GDP growth in relation to growth in the US and Germany, 1991-2017
Establishing a long-run fiscal target
The financial crisis of 2008/09 as well as all major crises in recent decades demonstrate that stable public finances are necessary for a proper fiscal response to the crisis-induced decline in economic activity. Consequently, we suggest an insurance approach for the design of the rules for public finances: fiscal policy should be framed today so it can successfully deal with the worst-case scenario of a deep financial crisis. As such, a crisis should be met with debt-financed expansionary fiscal measures, fiscal space before the next deep crisis should be sufficiently large to allow the government to respond to a future crisis with aggressive fiscal measures without running into restrictions of financing and sharply rising interest rates.
In other words, a low prudent level of national debt before the next crisis gives rise to sufficient fiscal space. In addition, the size of the fiscal multipliers is most likely larger when government debt is lower and trust in the government’s ability to sustain the debt is high. Government actions to limit the real economic effects of crises thus become more effective and the output cost of crises is reduced.3
Entering a crisis with a low public debt is also important for maintaining political stability. A low debt level before the crisis reduces the likelihood that the government has to implement major austerity measures during or immediately after a crisis with potentially devastating political effects of the type seen from recent events in Southern Europe.
We acknowledge that having too low a debt ratio can potentially also be harmful. Sustaining large and consistent budget surpluses risks ignoring vital public investments. High taxation in relation to spending would drain resources from the private sector. Intergenerational considerations imply that future generations should pay for public investments made by present generations. Completely eliminating government debt, and thus government bonds, would make it more difficult for private sector investors to price and handle risk. Eradicating all government bonds removes the infrastructure necessary for issuing debt and servicing debt in case of a nation-wide emergency such as a deep financial crisis. Consequently, there are several benefits of having a public debt relative to no debt at all. The challenge is to find the precautionary or prudent level of debt for the long run – neither too low and nor too high.
For Sweden, based on the historical record, we find a long-run fiscal target or debt anchor at a debt-to-GDP ratio of 25% of GDP to be appropriate. We establish this level in two steps.4 First, we estimate at which debt level the cost of servicing public debt begins to rise sharply. The premium on Swedish bond yields compared to German yields are closely related to the Swedish debt ratio. The premium is close to zero for debt ratios of 40% and below. They increase linearly thereafter. Sweden’s ability to service its debt becomes problematic when the debt ratio hits 70%, according to the record from the mid-1980s and onwards.
Second, starting from this level, we deduct the average fiscal cost of financial crises since the 1980s as estimated by Laeven and Valencia (2018). From these calculations, we conclude that Sweden should be able to increase its debt ratio during a future major financial crisis by up to 40 percentage points without facing rapidly increasing debt financing costs.
From these calculations, we recommend a debt anchor of 25% +/- 5 percentage points for Sweden, thus lower than the present one set at 35% +/- 5 percentage points.5 The appropriate debt level may be different for other countries, although not radically different for small open economies. Ideally, the actual debt ratio should be at the lower end of the corridor during booms to allow debt to rise during recessions, reflecting the workings of the automatic stabilizers and limited discretionary short-run fiscal measures.
Our design of the fiscal policy rule based on a long-term debt target resembles inflation targeting. Monetary policy is set to achieve the numerical target over the medium to long run while allowing temporary variations over the business cycle. The same approach should be used when designing fiscal policy. For democratic reasons, fiscal policy cannot be run by a fully independent body, similar to an independent central bank as fiscal policy is inherently a very political issue – it deals primarily with distributional issues. However, a fiscal framework and an independent fiscal policy council would be a constructive way of facilitating the workings of a democratic society, by fostering long-run consideration in the fiscal policy process.
Conclusions
We derive three central lessons from the Swedish fiscal record. First, a well-designed fiscal framework facilitates an orderly fiscal consolidation over the long run. Second, fiscal consolidation as reflected in a falling debt-to-GDP ratio does not arrest growth. Third, fiscal consolidation should be halted at a proper or prudent long-run level. Debt should not be too high, nor too low. In our view, the fiscal target should be set such that it provides ample fiscal space to meet the fiscal demands created by a future deep financial crisis. We calculate this level for Sweden from data from recent financial crises. In a similar way, long-run fiscal targets can be calculated for other countries.
In our view, once country-specific fiscal targets have been constructed with a tolerance band to account for fluctuations in debt over the business cycle, a country with a debt-to-GDP ratio larger than its debt anchor should set a surplus target over the business cycle to reduce the debt level. In a similar way, a country with a smaller debt-to-GDP than the debt anchor has fiscal space to increase its debt until it reaches the fiscal target. The adoption of a debt anchor should be combined with a fiscal framework, preferably monitored by an independent fiscal policy council.
From the Swedish fiscal experience, we conclude that recent proposals for debt-financed fiscal policy will not deliver a promising future. Instead, the Swedish case from the last 25 years shows that stable public finances combined with supply-side policies is the recipe for economic stability and growth. Fiscal policy should follow strict rules that prevent unsustainable deficit spending during normal times while ensuring a sufficiently low public debt ratio and thus sufficient fiscal space to meet a future economic crisis. Presently, neither the US, nor Europe is stuck in a major economic crisis that warrants rising budget deficits.
To sum up, we should not listen to the Sirens’ song of fiscal activism. Interest rates will not remain low forever. Political populism should not be met by fiscal populism. The role of the economics profession is to bring out the connection between the short and the long run, a connection that is easy to forget in times of populism, low yields, and quick fixes.
References
Andersson, F NG and L Jonung (2019), “The Swedish fiscal framework – The most successful in Europe?” Lund University, Department of Economics Working Paper 2019:006.
Blanchard, O (2019), “Public debt and low interest rates”, American Economic Review 109(4): 1197-1229.
Debrun, X and L Jonung (2019), "Under threat: Rules-based fiscal policy and how to preserve it", European Journal of Political Economy 57(C): 142-157.
Furman, J and L Summers (2019), “Further thinking on the costs and benefits of deficits”, Peterson Institute of International Economics.
Jonung, L (2018), “Homegrown: The Swedish fiscal policy framework”, in R Beetsma and X Debrun (eds), Independent fiscal councils: Watchdogs or lapdogs?, a VoxEU.org eBook.
Jordà, O, M Schularick and A Taylor. (2016), "Sovereigns versus banks: Credit, crises, and consequences", Journal of the European Economic Association 14: 45-79.
Laeven, L and F Valencia (2018), “Systemic banking crises revisited”, IMF working paper 18/206.
Romer C and D Romer. (2019), “Fiscal space and the aftermath of financial crises: How it matters and why”, BPEA conference drafts, March 7-8.
Endnotes
[1] See Debrun and Jonung (2019) on warning for the erosion of fiscal discipline by low interest rates on government debt.
[2] See Jonung (2018) for the evolution of the Swedish fiscal framework.
[3] See for example Jordà et al. (2016) and Romer and Romer (2019) for the international evidence. Romer and Romer (2019: 12) note a “tremendous variation in the severity and persistence of output declines following financial distress”. They explain this variation mainly by differences in fiscal space across countries.
[4] See Andersson and Jonung (2019) for an account of these calculations.
[5] We do not rely on the vast literature on optimal government debt as it is inconclusive. Instead, we adopt a crisis insurance view where fiscal policy should allow for sufficient consumption and tax smoothing. We do not claim to have established an optimal fiscal target – only a sufficient, precautionary or prudent level for the fiscal target based on the evidence from financial crises.
