A financially Sound Economy

Eurostat, the EU’s statistical arm, recently published statistics regarding the EU’s net financial worth in the first quarter of 2021. This stood at -66.3% of Gross Domestic Product, a change of -9.1% compared with the similar quarter in 2020, though it was a slight improvement compared with the fourth quarter of 2020, when net financial worth stood at a record low.

In simple terms, net financial worth is the difference between the stock of financial assets and the stock of liabilities of general government. 

As might be expected, during the COVID-19 pandemic, liabilities of EU governments grew very fast as administrations responded to the hard blow to economies inflicted by COVID. In a few weeks, governments had introduced economic packages to counter the impact of severe restrictions, job losses and loss of confidence around the world. Were it not for subsidies and huge injections of cash, economies would now be in a much more dire state.

Matching the rise in liabilities, however was the growth in assets. From the first quarter of 2020 onwards, EU governments acquired assets to mitigate the economic and social impact of the containment measures on households and businesses. These assets include liquidity support, provision of loans as well as the postponement of the payment deadlines of taxes and social contributions. 

Government deficits rose significantly during the pandemic due to the increased expenditure as well as lower revenues. The financing of these deficits led to a growth in liabilities, which were financed by the issue of bonds and the provision of loans. Given the low-interest regime at the moment, the interest bill on these new liabilities was rather contained, but governments still increased their reserves held in deposits during the pandemic.

There are some huge differences in the net worth of EU Member States. At one end, in 2020, was Bulgaria with a ratio of -2.3% of GDP, while at the other end was Greece with a ratio of -179.6% of GDP.

The EU and Eurozone averages were -66.3% and -75.6% respectively. The chart above shows how net worth as a percentage of GDP in 2020 was 65% worse than it was in 2008. Over the same period, frugal Germany was able to lower the ratio to -33.1%, but spendthrift Italy more than doubled its negative ratio. Even Lithuania and Slovenia, who had a low positive ratio in 2008, experienced a considerable deterioration.

Malta stands out as an example of fiscal responsibility. It is one of just five countries whose financial net worth improved over the 12-year period, in spite of the Covid double-whammy in 2020.  The others were Finland, Sweden, Germany, and Denmark.  Malta’s net worth has improved from -50.5% to -40.9% of GDP.

Some have posited that there is a link between net financial assets and economic growth. From the chart which plots the two there is no clear link that stands out. Malta’s high economic growth matches the improvement in net worth, but Ireland’s net worth was worse even though the emerald isle almost matched Malta’s economic growth.  

This is, by far, the biggest cudo in the Labour Government’s economic management record since 2013. It is, of course, the result of a sharp focus of economic policy on the debt position, built on a realisation that excessive debt may undermine financial stability and hamper economic growth. 

Of course, as usual, extremes can be counter-productive. At one end, one could have a Mintoffian visceral aversion to debt, which sometimes stymied economic growth by excessive fiscal prudence even when the economy needed higher government spending. At the other end, one could have an unhealthy appetite for debt which is wasted on recurrent expenditure, like in Greece and Italy.

This is, by far, the biggest cudo in the Labour Government’s economic management record since 2013.

Indeed, leading studies have confirmed that a high debt ratio is inimical to GDP growth, but that it only becomes detrimental above a specific threshold value. In an important 2010 study, Carmen Reinhart and Kenneth Rogoff concluded that a public debt ratio of more than 90% of GDP is associated with lower GDP growth than if the public debt is smaller.

That famous research culminated in their 2011 book “This Time Is Different: Eight Centuries of Financial Folly”, which provided the intellectual underpinnings of the austerity policies with which they are associated. Leading policy-makers, such as the EU’s Olly Rehn and US Republican politician Paul Ryan seized on the findings to support their austerity prescriptions.

Of course, now everybody knows that Reinhart and Rogoff’s study was a fiasco. That, in itself, is a famous story. When they talked about their study during the annual meeting of the American Economic Association, listening to them was Thomas Herndon, a student at the University of Massachusetts. His professors had given him an assignment: to pick an economics paper and try to replicate its results.  He chose Reinhart’s and Rogoff’s paper. The rest is history.

Herndon spent months analysing the figures and was able to figure out that programming errors and data omissions vitiated their conclusion. Fifteen professors from his University joined him to produce the famous paper which rendered that by Reinhart and Rogoff infamous. They found that high levels of debt are indeed still correlated with lower growth – but the most spectacular results from the Reinhart and Rogoff paper disappeared. High debt is correlated with somewhat lower growth, but the relationship is much gentler and there are lots of exceptions to the rule.

Paul Krugman, the Nobel Prize winning Princeton economist, never bought the line that high debts cause low growth. Instead he sees a negative causation: that low growth causes high debts.

Of course, to the uninitiated, these esoteric debates may sound like an academic kerkuffle of no consequence to the real world. They are wrong. Imagine that Reinhart and Rogoff had published their paper in 2020, rather than ten years earlier. No doubt, the hundreds, if not thousands, would-be “economists” who populate the web would have been spreading misinformation on Facebook and castigating governments for incurring debt to pay for the effects of COVID. And many governments would have crumbled under the pressure.

In truth, whether a country as financial soundness, such as a new financial assets position, is often determined in the financial markets and by credit agency ratings. Ratings ranging in the A category (A, A+, A2) with a stable or positive outlook mean that our credit rating is on a par with that of Ireland, Japan, and Saudi Arabia, to mention a few.

While our public debt is mostly held locally, and we rarely raise money overseas, the credit ratings are a sure sign that the international credit rating agencies view Malta’s economy as a financially sound one.

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