The 2008 crisis depressed EU economies still Poland was able to avoid a contraction in GDP growth, partially due to a fiscal stimulus. Following Keynes’ theory, during a financial crisis a fiscal stimulus allows an increase in aggregate demand, thus avoiding strong economic crisis and smoothing business cycles.
Although Poland is one of Europe’s relative success stories, this economy has run consecutive budget deficits in recent years financed through Government Debt.
Despite the effort made by Poland after 2009 to decrease its deficit, its debt is increasing substantially. Nevertheless, indebtedness can be sustained for a long time if Poland’s fiscal adjustment is credible to investors. If financial markets believe Poland is able to repay its debt, i.e. there is a small risk perception. A relatively low return on government bonds is asked allowing Poland’s financing costs to not increase dramatically. This seems to be the case given that government bonds’ yields are relatively low, with real GDP growth ranging from 2 to 5 percent, along with stable inflation, as shown in the graph below.
However, one should bear in mind whether this credibility can be sustained when faced with an increasing government debt. Until recently, even highly indebted, Poland have been paying an interest rate lower than its nominal GDP growth, allowing for the change in debt-to-GDP to be relatively low.
Nonetheless, a serious problem might arise if this scenario reverts. Poland has been showing a decreasing trend in nominal GDP growth which means that it might be the case that it ends up as several European countries, paying an interest rate higher than nominal GDP growth, leading to a snowball effect for the public debt (initial debt builds upon itself, becoming larger and larger).
Moreover, market expectations play an important role setting interest rates and might deepen this problem. Even though Poland’s debt-to-GDP is lower than some countries in the EU, creditors largely compare it to other Eastern European countries; in that matter Poland has one of the highest debt-to-GDP ratio. In addition, markets might feel that Poland’s ability to repay is decreasing. All these factors might drive investors to ask for a higher rate of return on debt, exacerbating the snowball effect. This may lead to the so called Self-fulfilling prophecy – the higher risk perception the higher the interest rate, and the higher the interest rate the higher the risk of non-repayment.
Despite the fact that Polish government has made an effort to reduce the deficit, it eventually has to repay its debt. And keeping postponing that commitment will necessarily imply larger future primary surpluses.
It is understandable that given the economic conjuncture of the 90s, structural reforms were needed and with that the necessity of higher deficits. However, due to the fact that Poland is now much more indebted, it has to take into consideration excessive deficits while trying to implement structural reforms, taking advantage of a future boom (applying again the same reasoning of smoothing Keynesian fiscal multiplier).
In the medium term, fiscal consolidation can be attained with other avenues rather than higher taxation. Enhancing cost efficiency in public administration is one of the objectives of Polish government, which is has one of the lowest cost efficiency in the OECD (OECD, 2010b). Nonetheless, implementing some of these key measures may be social and politically difficult constituting one of the major challenges in fiscal policy. Due to the large number of public employees in Poland, this measure has to be made carefully in order to avoid a promptly contraction of the internal demand (which has been one of the main boosters of the economy).
To sum up, Poland is seen as an example for the transition economies in Eastern Europe due to impressive results in catching-up other EU15 members. Still, it will have to manage the increasing debt and avoid following the path of other periphery countries. Markets seem very confident in Poland’s performance but as history has showed “animal spirit” is hard to predict and control for. It may be the case that the deficits will be inverted when the economy cycle starts to boom. Nevertheless, the later the fiscal adjustment the hardest it is for the economy.
#705 and #693