Week 10

Question 1

4 reasons for large primary deficits

Answer 1

1. Financial crisis
2. Covid shocks - furlough schemes, unemployment benefits
3. War
4. Fiscal policies that tried to buy votes (also tax cuts)

Question 2

Reasons for high debt-GDP ratio

2 factors for a change in the ratio

Answer 2

1. Interest rate > Growth rate
   - when growth rate is low and ratio is high, also leads to investors asking for even higher interest rate
2. Large primary deficits (see previous flashcard on reasons)

Change in ratio depends on the primary deficit + DIFFERENCE between interest rate & growth rate (it - gt)

Question 3

What is the implication when interest rate payments are a big proportion of the debt-GDP ratio?

Answer 3

Govs have to run high primary SURPLUSES to compensate, or else the ratio will keep growing and never STABILISE

Question 4

Why is it that Italy and Japan can have extremely high debt-to-GDP ratios (above 100% and 200%) yet investors do not consider them at risk of default?

Compare the situation w/ Argentina at the beginning of the 21st century. Debt-to-GDP reached 65%, increasing for several years from 35% in 1996, and the country then was struck by a crisis which lead to default in 2002.
Why do we have these very different outcomes?

Answer 4

Among investors there is a reasonable understanding that Italian and Japanese governments will be able to reduce spending, and raise and collect taxes in their economies without destroying the production capacity.

Investors were not convinced the Argentinian government will be able to do the same, so a lower level of debt was deemed high & increasing ratio over time confirmed investors’ belief.
1. The gov didn’t seem to have intentions to reduce the deficit
2. The economy was hit by several shocks in the commodities markets, from which a large part of the tax revenues was coming from.
» Investors not convinced that the debt was sustainable so stopped lending to the gov
3. Starved of funds & incapable of reducing the deficit w/o making economy collapse, the Argentinian gov started printing money -> huge inflation = worse
4. Finally default was the only option