On Monday, the Financial Times reported that the International Monetary Fund (IMF) is once again concerned over Greece’s failure to maintain a primary surplus, this time for 2015. The IMF historically has approached sovereign solvency issues predominantly from a mathematical perspective, and to them, the math remains clear. Without a persistent primary surplus, “debt relief” appears inevitable, i.e. defaulting on their existing bailout loans.*
I felt it might be timely to share a quick write-up on debt sustainability, because it is once again at the forefront for Greece, as well as right around the corner for Puerto Rico. “Primary surplus” is a term which is thrown around frequently in the context of debt sustainability discussions, but it is a slightly strange concept, even though the definition is simple. The primary balance (surplus or deficit) technically means the government budget balance excluding interest payments on the debt stock. So far so good. But why should we exclude interest payments on the debt when considering a government’s budget deficit? Surely interest payments matter! Deficits of any kind should imply increasing debt, not just deficits excluding interest payments.
The answer is two-fold. First, the primary budget balance more accurately reflects the pain inflicted (in the case of a primary surplus) or indulgence bestowed (in the case of a primary deficit) by the government on the economy of the country in question. The primary balance represents the difference between the amount that the economy pays to the government in taxes, and the benefits the economy receives back from the government in the form of total expenditure on stuff that matters (infrastructure, defense, education, health, entitlements, etc.). It turns out that running primary surpluses can be extremely painful for an economy (even if the total budget is in deficit after interest expense), particularly when a society is not accustomed to paying in more than they get back. When an entity such as the IMF is evaluating the austerity capacity for a troubled sovereign, primary balance is the sensible variable to target, because it’s a truer measure of the pain.
Secondly, in analyzing debt sustainability mathematics, the interest payments are typically considered separately from the rest of the budget balance, because it’s easier to conceptualize (at least in my opinion). The debt-to-GDP ratio is the most common measure of a country’s indebtedness, and big-picture, there are two ways to shrink it**, all else equal: 1) the country’s real GDP growth (g) can exceed the real interest rate (r) on the debt stock, and/or 2) the country can run a primary surplus. The change in debt-to-GDP ratio in a given year is basically the sum of these two effects, so they can potentially offset each other usefully. For example, for every year that GDP growth is in excess of the average interest rate, the country may run a primary deficit equal to the difference between g and r without growing the debt-to-GDP ratio. In my mind, this is the real reason why the political apparatus in democracies over the past 150 years has been in pursuit of economic growth. Economic growth allows governments to run continuous primary deficits of a certain size, without growing the debt-to-GDP ratio. Primary deficits beget happy voters. Primary surpluses beget angry voters, and you need look no further than the parliamentary turnover throughout peripheral Europe since the depths of the euro crisis to see the evidence.
The implication of these simple relationships is that GDP contractions, high interest rates, and primary deficits are each individually bad for debt dynamics. In concert, they’re terrible. Puerto Rico has had the trifecta, and I see no easy escape without a default. Strangely I think a default is the escape, but that’s a topic for another blog. Greece would have all three, were it not for exceptionally low concessional interest rates they have received in their prior bailout programs. The IMF is right to be concerned. The real question whether they will be able to focus on the math and truly ignore the politics. If so, this time is different.
*Spiegel, Peter. (May 4, 2015). IMF takes hard line on aid as Greek surplus turns to deficit. Financial Times.
**other than defaulting