Switzerland leads the way. The threat of national bankruptcy and the euro crisis make the debt brake today’s hottest commodity. Its success story began with a referendum.Switzerland's debt brake is taking effect | Credit Suisse Bulletin 6/2012

Switzerland does well in an international comparison: In Europe and the US, national debt has all but exploded, and national bankruptcy is now a real threat in several European countries.

In Switzerland, on the other hand, national debt – measured against the gross domestic product (GDP) – has fallen since 2003, from 55 percent to about 35 percent. This meant an impressive reversal in the trend for Switzerland, because as late as the 1990s, the debt ratio of the national budgets was consistently above 50 percent.

The success story began in 2001, when a referendum approved the introduction of a debt brake with 85 percent of the country voting in favor of it. This made Switzerland the first country with a constitutionally underpinned debt brake. It entered into force in 2003. Its basic principle is simple: Expenditure must not exceed revenues during the course of a single business cycle. While in economically difficult years, a deficit is allowed, in good years the deficit must be offset by surpluses. This brought about budget consolidation that occurred even as the growth phase was proceeding, enabling Switzerland to generate budget surpluses even in times of crisis.

In many other industrialized countries, on the other hand, government debt has continued to grow, even in good economic times. And when the most recent crisis occurred, public budgets went out of control. In the US, the national debt has swelled from 11 trillion US dollars to 16 trillion dollars (2009-2012). The average debt ratio in the Eurozone also shot up from 66 percent (2007) to 87 percent (2011). It is likely to take an entire generation to pay off the debt of a single economic cycle, let alone one affected by a serious crisis.

Against the backdrop of this exploding national debt in Europe and the US, the debt brake has already become exportable. Germany incorporated it into its constitution in 2009. Even Poland, Spain, Hungary and Bulgaria have introduced debt brakes. What’s more, all countries in the Eurozone signed on to it as part of the fiscal compact.

Toxic Deficits

Most industrialized countries have now reached what is known as the “Keynesian endpoint”. Deficits that develop beyond this threshold value – which economists put at about 90 percent relative to the GDP – become toxic: First, a spiral develops between interest burdens and new debt. For example, in 2010 in Germany, the government paid 37 billion euros in interest alone merely to service past debt. In normal years, therefore, new debt flows almost directly to paying off existing debts. In a second phase, risk premiums for government bonds rise sharply, as is currently happening in countries like Portugal, Italy, Ireland, Greece and Spain. Third, households and companies anticipate economic problems and higher taxes. They scale back on consumption and investments, thereby neutralizing the pace of demand set by higher government expenditure.

A mandatory debt brake is therefore not just a tool suitable for stabilizing expectations and interrupting this vicious cycle; it also seems to be indispensable in forcing governments to maintain sustainable budgets. The short-term orientation of politics ensures that advocates of anticyclical fiscal policy only become vocal when there is a downturn. Once the economy resumes growth, the principle of anticyclical planning is forgotten as new debt piles up. For example, over the past 30 to 40 years in France and Germany, not a single economic cycle has yielded a balanced budget – let alone a surplus from an upswing. Politicians are financing shortterm campaign perks by making future generations foot the bill. Only national debt brakes – or a truly impermeable fiscal compact on the European level – can resolve this problem. Switzerland fortuitously introduced this instrument before the crisis, and its excellent fiscal situation is entirely owing to this step.

This article was published in the "Credit Suisse Bulletin" 6 / 2012.