Further derailment of the Belgian public debt is best avoided
Due to the Covid-19 crisis, Belgian public debt will increase to above 120% of GDP. Although the situation is not directly harmful today, the deterioration and high level of the debt nonetheless poses risks in the long(er) term. In this opinion, we make a number of simulations which illustrate that a further significant slippage in the debt is indeed possible. Such a development should be avoided as a precaution. In the coming years, fiscal consolidation should be managed in a growth-friendly manner as much as possible. By flanking it with growth-enhancing structural reforms, the deterioration in Belgian public finances can be reversed while also boosting potential growth.
The corona crisis is pushing the Belgian public debt towards an historic increase. According to the Monitoring Committee’s detailed estimate published at the end of July, the debt ratio is forecast to rise from 98.8% of GDP in 2019 to 122.1% in 2020. After falling slightly in 2021, the ratio is expected to rise again to 123.1% in 2024. Should we be worried now?
Why too much debt is not good
Government debt in itself is not bad. It is acceptable if it increases the productive capacity of the economy and if the return from debt-increasing measures (e.g. investment in infrastructure and education) exceeds the interest burden of the debt. Furthermore, the debt ratio must be assessed using the intergenerational neutrality criterion. By creating public debt, one increases the disposable income of the current generation to the detriment of future generations. According to the criterion, each generation’s net contribution to the debt must be equal. However, putting all this into practice, which would make it possible to calculate an optimal level of debt, is not obvious. Nevertheless, the very high level of debt reached in Belgium, even in comparison with most other EU countries, probably deviates from what can be considered optimal from a socio-economic point of view.
A high level of debt involves economic risks. First of all, there will be doubts about the sustainability of the debt, in particular with regard to repayment and interest payments. Usually, this is especially the case when a large part of the debt is in foreign hands or in foreign currency. This is not currently the case in Belgium: about half of the debt is held by residents and the entire debt is issued in euros. Doubts are exacerbated when there are high costs associated with population ageing. This is the case in Belgium (see below). Ultimately, the entire financial system could be in crisis because banks are traditionally large buyers of public debt in which they invest part of the collected savings deposits. The adjustments required to reduce an out-of-control debt are often substantial and dramatic for the population.
A high level of debt also makes public finances vulnerable to a rise in interest rates. A larger part of the revenue then has to cover interest costs so that other expenditures, often the more productive ones such as investments in infrastructure, are squeezed out, unless the tax burden is increased. Ultimately, the debt may derail if the average interest rate on the outstanding debt exceeds nominal GDP growth (the snowball effect). With current low interest rates, that risk is ruled out for the time being. However, a high debt ratio does make public finances more sensitive to an interest rate increase when interest rates return to normal market logic in the longer term. A sharply rising debt can in itself cause interest rates to rise, which in turn acts as a brake on private investment (the cuckoo effect).
Economic growth can be negatively affected by all of this. This is even more so when citizens start saving more in anticipation of higher future taxes in order to be able to pay off the high debt (the Ricardian equivalence). However, opinions among economists differ as to the extent to which a high public debt cripples growth. It is not because there is a link between high debt and low growth that low economic growth was caused by high debt. It may be that conversely, low growth leads to high public debt because there is less tax collection and more expenditure. Whether high debt is harmful also depends on specific economic and institutional characteristics that differ from country to country. Factors such as weak institutions, low competitiveness or a vulnerable banking sector also determine the extent of the impact that high public debt has on economic growth. The perception by the financial markets of the solvency risk and of the general economic stability of the country in question is also a crucial element.
The situation in Belgium is certainly not problematic in these areas today, although there are some concerns (think of the difficult formation of a new federal government and the lack of further reforms). Nevertheless, a further slippage in public debt is best avoided as a precaution. To illustrate that there is a real risk of this happening, we have made a few simulations (Figure 1). According to the Monitoring Committee, the primary balance (i.e. the budget balance excluding interest payments) will still be -3.9% in 2024 (assuming unchanged policy). If the primary deficit were to remain at that level from 2025 onwards, the debt would rise to 190% of GDP in 2050. Moreover, if we allow the deficit to deteriorate further to the extent of the costs of ageing expected by the Belgian Study Commission on Ageing, the debt ratio would even peak at 235% in 2050. For the purposes of this simulation, we assume that nominal GDP growth will be 3.3% per annum from 2025 onwards (1.3% real growth and 2% inflation) and that the implicit interest rate on the debt tends towards 2% in 2035 (in line with the expected rise in long-term interest rates), then 3% in 2040 and remains at that level thereafter.
Higher GDP growth and/or lower interest rates after 2025 would make the debt path less steep. But we have to assume fairly extreme figures (e.g. 2.5% real growth and 2.5% inflation per year and an implicit interest rate that only rises to 1.5% in 2035) to stabilize the debt at the level of 2024 from 2025 onwards, assuming a primary deficit of -3.9%. This means that fiscal consolidation is essential if the debt is to be brought down. The figure illustrates that, in order to permanently reduce the debt ratio, a primary surplus must be built up and maintained. The path assumed in the figure towards a primary surplus of 1.7% of GDP by 2030 implies an overall budget deficit of -3% in 2024 (i.e. the ambition that is currently on the table in the negotiations to form a new federal government) and then an overall balance in 2030. This path would be very ambitious and would require not only the elimination of the current deficit, but also the absorption of future ageing costs.
It is important that the fiscal consolidation does not become counterproductive. After all, too fierce austerity measures would depress economic growth, which could cancel out the planned debt reduction. This should not, however, be an excuse for doing little or nothing. By restructuring as much as possible in a growth-friendly manner (e.g. increasing government efficiency, avoiding new taxes as much as possible, greening taxes, not cutting back on public investment) and flanking the restructuring with growth-supportive structural reforms (e.g. further reduction of administrative burdens, making labour and product markets more flexible), the deterioration of public finances can indeed be reversed while also boosting potential growth.