PUBLIC DEBT LEVEL AND THE CONSTITUTION

Abstract Public debt is like atomic energy. It should be used with caution and for fruitful purposes otherwise it can bring disastrous consequences for the economy of a country or a region. This article argues why is that the debt ceiling level of 60% is considered optimal under the lens of the IMF, WB, EU legislation, HSC and other economic actors. The debate on this hot topic is far more hectic than ever, due to the financial crisis, almost Greek economic bankruptcy and generally unfavorable economic climate in developed countries. Some of the arguments in favor of setting the ceiling level of public debt identified here are: increased security in showing care to governmental expenditures and increased financial and political stability in the country and the region, lower probability of transferring political risk to country or social risk, maintaining low interest rate level to stimulate rapid economic growth and satisfactory employment, improved socio-economic picture, and not only, for Albania in the international arena, and Albania has no actual manufacturing capacity to support high level of public debt. JEL Classification: E43, E62, G01, H63, H83 Key words: public debt, optimal, binary tree, the financial crisis, ceiling limit. Prologue In the Maastricht Treaty is clearly specified, among other things, that the government finances for a European Union member country should not exceed the limit of 3 per cent budget deficit to Gross Domestic Product (GDP) and over 60 percent of government debt to GDP. The reasons to fixate these limits at that time aimed to create stability, reliability and consistency between Member States and those who would like to eventually join the Union. Today, nearly 20 years later after the Treaty was signed, almost all member countries except Poland and the Czech Republic, did not comply with these limiting conditions. Germany, the European Union's economic locomotive, has a public debt at 84% of GDP. France floats in the same waters (in September 2012, its public debt jumped to 91 percent of GDP), while other countries are in free fall into the vicious spiral of debt. European Central Bank, in its April 2012 study entitled "Analysis of the sustainability of government debt in the euro area", stated that in 2008-2011 period of crisis in the Eurozone countries, the level of public debt has increased by 22 percent, capturing thus an average of 88 percent of GDP per each country. Amplified by the financial crisis of 2008 onwards and the escalating Eurozone problems, the threat of debt has taken such proportions so that many EU member countries are trying to amend the Constitution to include a bill which will eventually limit the permitted level of public debt, while many other countries have done so already. Poland, Spain, Italy, Germany, etc., applied the so called "Schuldenbremse" - "debt brake" to bring their budgets and debts into balance. But is the public debt the epicenter of the economic downturn of these countries, or simply a crisis amplifier?

Dr. Bujar LESKAJ

Some rough arguments as to why the level of debt should be embedded in the values of 40% for developing countries and 60% for developed countries are as follows 1: 1. The upper limit of debt increases security by showing that the government carefully monitors its costs, hence increasing the financial and political stability in the country and the region. Let us recall as an example the case of Italy, a significant part of the public debt of which is held by France, around 20%. Italian public debt goes over 120% of GDP, and if the government will not be able to repay, financial "stress" would extend in France and beyond. Let us also remember that Italy is currently under the management of a technical government, the primary purpose of which is the emergence of the financial crisis and putting under control the macroeconomic indicators. 2. Low probability of transferring political risk into country or social risk. Often governments tend to finance their political programs relying inappropriately on public debt. This is especially true at the end of government mandates, when an increase in public investment is observed and where the primary fund used is public debt. Such actions have a huge social cost and could turn into a bad pattern of doing politics. 3. Preserves the low interest rate to stimulate rapid economic growth and satisfactory employment. If public debt would increase to higher levels, this would be accompanied by a rise in interest rate used by the public and private sector. The growth rate would reduce credit-granting, hindering the growth of the real and financial sector. Consequently it will reduce employment and deteriorate further financial macroeconomic variables such as inflation, liquidity, political risk, exchange rate, etc. 4. Improves the economic image, and not only, of Albania in the international arena. Let us recall the reduction of the quality of public debt in some countries by specialized rating agencies, such as Moody's or S&P. Reducing public debt rating causes: increased risk of bankruptcy, lack of ability to be financed with debt in the future, capital outflows and deeper budget deficits. 5. Albania has no manufacturing capacity to currently support the high level of public debt (the budget revenues are generated from taxes and duties, which themselves are generated by the level of production or GDP) and an increase of debt in times of crisis or stagnation further inhibits the rapid growth of these capacities. The purpose behind public debt use as a source of funds is the performance of government spending. These costs generally produce indirect and long-term effects on financial incomes of the private sector, while public debt service requires shortterm flows. In this regard, the amount of public debt should not only be limited as a percentage of GDP, but the structure of the debt within this limit must be such that the financial shock be immunized as much as possible, being consistent with maturities of government priority spending. This is generally achieved by issuing long-term debt and the Albanian government has realized this in recent years, because of public debt policy is oriented towards long-term versus short-term stock growth. However, despite the above arguments, we must state it clear that the public debt is not a problem in itself. It simply amplifies the effects of economic growth or crisis, so in other
1

Figures pertaining to technical studies carried out by the IMF.

The Public Debt Level and the Constitution

words it is "a double-edged sword." It is true that in time of crisis, the debt, and especially the public one, harms more than it helps, but in periods of rapid growth, debt is the catalyst by multiplying the positive effects. But even in periods of growth, limiting public debt still remains a valid option because it frees funds that can be used for granting credit and making loans to the private sector, which in a successful market economy, optimizes better than public sector the economic and financial decision-making. Theory of public debt Public debt is defined as debt issued by the central government (although in many cases introduced here is also the local bodies debt). This debt for a given year is equal to the budget deficit in that year, resulting as the difference between income and government spending, which is financed with borrowed resources. Depending on who holds the debt, it is classified as domestic when it is owned by domestic residents and foreign debt when it is owned by foreigners. For Albania, the stock of debt for the first 6 months of 2012 was 33.30% and 25.55% of GDP respectively, for a total of 58.85% of GDP. Also, depending on the maturity of the instruments used in providing the debt, it is divided into short, medium and long term. The Albanian government has aimed at increasing the share of medium-term versus short-term debt stock. For the first 6 months of 2012 the share of medium-term debt was 67% of total debt. 2 Generally, the objective of the government regarding public debt is "meeting the financial needs of the government with the lowest possible cost over time." But other than that, especially for emerging market economies, public debt management aims not only the costs and risks of the debt, but also the sustainability of government debt levels. Numerous studies address exactly the optimal level of government debt to reflect and to assess its viability. Usually the center of these studies is the International Monetary Fund, a key institution assisting and monitoring the performance of fiscal, monetary and financial policy of a member country. These studies highlight the level of 60% of the ratio public debt/GDP as border care in developed countries, while for developing countries the 40% level seems to be more appropriate, at least in the long run. In the 2010 report, published by the Fund's Fiscal Affairs Department, was offered a "fiscal correction" to be taken by developed and developing countries in order to converge towards these suggested figures of the public debt/GDP in 2030. So literature treats these levels as "optimal" in the sense that overcoming those poses risk to debt sustainability. In fact, this is also in line with the Fund's macroeconomic model that attributes a dual role to fiscal policy: 1) to smooth business cycles in the short term; 2) to achieve the objectives for debt sustainability in the long run. But is a 60% level an optimal one in the theoretical sense of the word? This figure is actually written explicitly in the Maastricht Treaty as a preparation measure at that time for European countries to create the European Union and then the Eurozone. At that time there was no proper survey, the figure was only the median 3 ratio of debt to GDP that had the majority of European countries. The only initial study mentioning this figure is an article titled "Sustainability Assessment", prepared by the Policy Department in collaboration with the Departments of Fiscal Affairs, International Capital Markets, Foreign Monetary Affairs and Research and Development within the IMF. Study dated 28 May 2002 and the method it
2

Including debt maturing within one year, but that has initial long-term maturity. If you exclude this part, then the weight of medium-term debt falls to 58% of total debt. 3 Median value. It differs from the average and mode.

Dr. Bujar LESKAJ

uses to conclude on the level "optimal" debt is CART 4 (more specifically recursive binary tree). This method determines the threshold level that discriminates best between debt crisis from non-crisis, while minimizing the statistical errors of the type 1 and 2. By applying the method to these data, was generated the resulting threshold level of 44.7% public debt/GDP. For countries with debt ratio below this threshold, the probability of the debt crisis is 2-5%, while in countries with higher ratio than this threshold the conditional probability jumps to 15-20%. In other words, even if developing countries exceed this threshold, the probability that the country does not fall into insolvency is 80%. If the model included an additional input, such as the exports/GDP ratio, the conclusions vary. The introduction of this additional indicator in the model is justified by the study, arguing that the country must generate trade surpluses to service the public debt. Reapplying binary tree, the model concludes that if the ratio exports/GDP is 20-40%, the optimal upper threshold for debt is 60-80%. Similarly, in its article of September 2010, "Fiscal Space" 5, the IMF states that generated debt limits in its studies "are not an absolute and immutable barrier ... . Also, this limit should not be interpreted as the optimal level of public debt." In this article based on the study of 23 developed countries, the limits of debt recorded using differential growth rate interest rate, ranged from 150% to 260%, with median 192%. Assuming that the difference between the growth rate and the interest rate in the future will not be as favorable as it was in the past, the study concludes that long-term debt limit must converge to 63%, and to a maximum of up to 183% of GDP. Other scholars do not seem to share the same opinion with the IMF. In 1944, Evsey Domar stated that: "The debt problem is essentially a problem of national income growth." He would defend the same position 50 years later when he stated that: "the right solution to the problem of debt is not to put on the straitjacket, but to accelerate economic growth." The reality of public debt Despite high levels of public debt in the past, levels which are not accompanied by high inflation or inflated interest rates, the financial crisis of recent years and the failure of Greece have increased the sensitivity of financial markets and political circles to public debt. To politically manage public debt, many countries are creating laws that address mainly the budget deficit and indirectly the public debt. Switzerland has amended its constitution in 2001 to curb the level of public debt. Implementation of this amendment came into force in 2003. Under this law, the budget must be balanced, in line with economic conditions. Correction according to economic conditions is done by multiplying the government spending with a cyclic factor (the ratio of real GDP trend to GDP forecasted). In this way there are deficits allowed during periods of recession and are surpluses required during periods of economic boom. In essence, the law seeks structural balance each year and absolute balance within an economic cycle. Initially, the law allowed the making of "extraordinary expenses" with the approval of a qualified majority in parliament, but recent changes are treating these costs as normal. In 2009 Germany amended its constitution to introduce "debt brake". This law will apply to the federal government and the Lnder. From 2016 onwards the federal government is forbidden to have a structural deficit more than 0.35% of GDP, while from 2020 onwards
Classification and Regression Tree. "Fiscal space" is defined by the authors of the article as the difference between the maximum permissible limit of public debt, as determined by historical statistics of fiscal correction, and the current level of debt.
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The Public Debt Level and the Constitution

Lnder would not be allowed to have any structural deficits 6, except in cases of disasters or crises linked to difficult economic conditions. Regarding the amendment of the constitution by Germany to the problem of public debt, Noah Feldman, professor of constitutional and international law at Harvard, says that the Germans "are behaving like Odysseus who tied himself to a mast to escape the temptation of the sirens". But in fact, the constitutional show put forward by Merkel and Sarkozy aims to make it clear to the most problematic Eurozone members that their poor economic performance will not drag down the entire European Union and then ask Germany and France for assistance to draw them out of the crisis. By fixating the public debt level into their constitutions, member countries show political will and discipline to be the solution and not the cause of problems. In a broader context, this means the starting point for the unification of fiscal policy, as was the monetary policy unified with the introduction of the Euro on 1 January 2002. So politically, Germany and France are making a good use of financial crisis by creating a Union economy worthy to compete to US in the West and Japan in the east. Austria, Italy, Spain, Poland have taken all the necessary steps to amend their constitutions according to the German model and implicitly or not aim at bringing the public debt at the suggested 60% of GDP. German "Schuldenbremse" has yet to be tested in these countries. But ultimately we all know how well-performing is German engineering, even in economy. The U.S. has historically applied a limit on the public debt. Since 1917 Congress instituted the "debt ceiling." To change this ceiling it requires the approval of both Houses of Congress. Since 1962 the U.S. debt ceiling is increased 74 times, Ronald Reagan being the record-man of change. Many states in America have amended their constitution to include balanced budgets, but this is not achieved at the federal level yet. In the U.S. Constitution, Article 1, Section 8 is clearly specified: "The Congress shall have power. . . To borrow Money on the credit of the United States. Japan currently has the largest public debt in the world, almost twice its economy consisting of $5 trillion GDP. Japanese legislation is strict in terms of public debt. So the government, according to the Public Finance Law, 1947, allows only "construction bonds", i.e. debt issued to finance expenditures made for asset creation; in other words for public infrastructure investment. Debt issuance to finance the budget deficit, i.e. to cover the public consumption or uncollected income is prohibited. However, this law actually remained only on paper. Albania and Public Debt In 9.936 organic law "On budget system management in the Republic of Albania", is explicitly specified to "Article 58", "point c" that: "total public debt, including guarantees, shall not exceed the limit of 60% of the Gross Domestic Product." This law is constantly respected by the Ministry of Finance. As a peripheral economy and partly integrated with the European economy, Albania has been unaffected by the crisis to some extent. Consequently keeping public debt level target border has been relatively easier than in other countries within the Eurozone. Albanian government's long-term public debt is currently classified by "Standard & Poors" as class B+ debt, while the short-term as Class B. The reasons for this classification are as follows: 1. The relatively low prosperity of welfare; 2. High level of government debt relative to income;
Structural deficit is the budget deficit, regardless of the economic cycle, thus the deficit persistent through time.
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Dr. Bujar LESKAJ

3. High exposure to various factors, due to large deficits in the current account; 4. Uncertain political environment. However, the rating can be improved in the future as a result of: 1. 2. 3. 4. Solid economic growth performance; Strong economic potential in the long term; Legal structure that gives high priority to service the public debt; Long-term perspective integration in the European Union.

Similarly, S&P says that the short term growth ratio will be 2-3%, while in the long run it can reach the full 5-6% potential. This economic growth, and therefore the reduction of debt to improve its classification, can be enhanced by improving competitiveness and business climate, reducing bureaucracy, solving property problems, reducing the informal economy and expanding the tax base. If Albania wants to join the European family in terms of a unified fiscal policy and especially in the area of public debt, then proper scientific studies should be undertaken by the Ministry of Finance, the Bank of Albania, universities and other economic stakeholders. Last year Albanian economy had a budget deficit (the difference between government spending and revenue) of 3.5 percent of GDP, while the deficit in 2010 was 3 percent of GDP. Our public debt in 2011 was also increased to capture 58.8 percent of GDP. 2013 election year challenges ahead require a forecasted budget discipline even more cautious. Although, as noted above, the Law on Budget System Management provides the limit of 60 percent of GDP for public debt, its fixation in the Constitution would serve exactly to the prudent budgetary discipline necessary for the current situation, but also to the long-term economic development of the country. These are the reasons why the High State Control, in his Report on the implementation of the State Budget of 2011, suggested to the Government that the country's public debt ceiling of 60 percent of GDP must be fixed in the Constitution of Albania. High State Control remains completely confident that within two years after extensive discussion with the stakeholders and legislative, political and economic actors this will be achieved successfully. References 1. "Consolidated Version of the Treaty Establishing the European Community", Official Journal of the European Communities, 24.12.2002. 2. "Guidelines for Public Debt Management", IMF & World Bank Publications, 2003. 3. "Assessing Sustainability", International Monetary Fund, 28.05.2002. 4. "Analyzing Government Debt Sustainability in the Euro Area", European Central Bank, Monthly Bulletin, 04.2012. 5. "Public Debt Management and Fiscal Vulnerability: Potential Roles for SAIs" INTOSAI Public Debt Committee, 02.2003. 6. "Balanced Budget Acts as Dumb in Europe as in U.S.", Prof. Noah Feldman, 22.08.2011. 7. "S&P affirms rating on Albania Debt at 'B+/B': outlook is stable", 07.12.2012, http://noa.al/news/artikull.php?id=258902.