Public debt: reduce or write off?

Since the Cov­id crisis, pub­lic debt levels have been extremely high (116% of GDP at the end of 2021 in France, for example). As such, it has reignited the debate on the risks asso­ci­ated with such a level of debt, giv­ing rise to very spec­trum of opin­ions. For some, it is inev­it­able that we are head­ing for a sov­er­eign debt crisis giv­en the high level of debt and the pre­dicted rise in interest rates. Where­as for oth­ers we should fur­ther increase our debt whilst interest rates are low to fin­ance neces­sary invest­ments – par­tic­u­larly the energy transition.

Moreover, anoth­er ele­ment has emerged: a sig­ni­fic­ant slice of pub­lic debt is now held by cent­ral banks and is thus recor­ded on the liab­il­it­ies side of these insti­tu­tions’ bal­ance sheets. There­fore, should it simply be writ­ten off as some eco­nom­ists have suggested?

Let us start with an ana­lys­is of this issue. Leg­ally, a cent­ral bank is part of the State (a 100% sub­si­di­ary, in fact). As such, it pays all its profits to the State so to get a bet­ter pic­ture we need to ana­lyse the con­sol­id­ated bal­ance sheet between the State and cent­ral bank. On the liab­il­it­ies side, we find the part of the debt that is not held by the cent­ral bank and the money recently prin­ted by the cent­ral bank to buy back fin­an­cial assets (mainly in the form of pub­lic sec­tor bonds). On the oth­er hand, the part of the pub­lic debt held by the cent­ral bank does not appear, since it is a claim of the State on itself, which there­fore does not exist.

As a con­sequence, the pub­lic debt left over can be con­sidered that which is not held by the cent­ral bank. In the case of France, for example, it is 90% of GDP – the same level as before the Cov­id crisis. So, there would be no need to can­cel pub­lic debt held by the cent­ral bank because there is no Cov­id debt. What we have is Cov­id money, which was issued by cent­ral bankers to fin­ance asset pur­chases. For me, the reflec­tion should there­fore be on the con­sequences of massive money cre­ation dur­ing the crisis – fin­an­cial instabil­ity, excess­ive rise in stock prices and infla­tion in prop­erty prices – and not on the con­sequences of the exist­ence of Cov­id debt.

Pub­lic debt levels before Cov­id were already very high. Moreover, it is now clear that many expendit­ures will have to be increased in the long-term. This is the case for cer­tain sec­tors in France as it is in all OECD coun­tries: rein­dus­tri­al­isa­tion, train­ing, edu­ca­tion, health, secur­ity, energy trans­ition, and innov­a­tion. The spon­tan­eous trend would there­fore be to con­tin­ue to increase pub­lic spend­ing, main­tain high pub­lic defi­cits and con­tin­ue to increase the pub­lic debt ratio.

Some eco­nom­ists do not see any obstacles to this devel­op­ment, arguing that low interest rates should be used to fin­ance use­ful expendit­ure such as the energy trans­ition. How­ever, cer­tain con­straints will return and restrict expan­sion­ary fisc­al policies. Let us take the case of France as an example. First of all, an insti­tu­tion­al con­straint: Europe will even­tu­ally put budget­ary rules back in place. These rules will cer­tainly be more flex­ible than before, allow­ing, for example, debt fin­an­cing of expendit­ure linked to the energy trans­ition. But these rules will prob­ably not allow all the pub­lic spend­ing envis­aged above to be possible.

Secondly, a fin­an­cial con­straint. Today, long-term interest rates are much lower than the long-term growth rate of the eco­nomy. For France today the 10-year interest rate is 0.2% whilst nom­in­al long-term growth, in value terms, is around 3%. The gap is there­fore con­sid­er­able, which allows for high­er pub­lic defi­cits as the pub­lic debt ratio spon­tan­eously falls. But the time will come when the ECB will reduce its bond pur­chases, because the euro­zone eco­nomy will approach full employ­ment and because rap­id money cre­ation will lead to an unsus­tain­able rise in prop­erty prices. The exit of the cent­ral bank from its pur­chase pro­gramme will inev­it­ably lead to a rise in long-term interest rates, res­ult­ing in a con­fig­ur­a­tion where the sta­bil­isa­tion of the pub­lic debt ratio will require a great­er effort to reduce the primary pub­lic defi­cit (exclud­ing interest on the pub­lic debt).

The above shows that in Europe, in the future, there will be a return to a budget­ary con­straint, with the need to reduce the pub­lic defi­cit. In France, it will fall from 8.4% of GDP in 2021 to 5% in 2022, but about half of this improve­ment comes from the end of the Cov­id crisis; this will no longer be the case in the future. What then are the policy options? A tax increase is pos­sible, and indeed envis­aged, in coun­tries with a low tax bur­den (United States, United King­dom), but dif­fi­cult to ima­gine in France where tax­a­tion is among the highest in the world.

In the case of France, a reform that sig­ni­fic­antly reduces pub­lic pen­sion expendit­ure – nearly 14% of GDP in France com­pared to 8% in oth­er euro­zone coun­tries – would provide the neces­sary budget­ary lee­way. But we should not under­es­tim­ate the res­ist­ance of pub­lic opin­ion to such a reform. There is then one last aven­ue, which is to improve the effi­ciency of the state in coun­tries where it is questionable.

When we com­pare the OECD coun­tries, we see that France is around the aver­age for the qual­ity of pub­lic ser­vices: health, edu­ca­tion, justice, secur­ity, labour mar­ket. But the level of pub­lic spend­ing is very high, even exclud­ing pen­sion spend­ing. If France had a nor­mal effi­ciency (pro­ductiv­ity) of the State com­pared to oth­er coun­tries, it could provide pub­lic ser­vices of the same qual­ity at a cost of 7 points of GDP less. It is there­fore neces­sary to reopen the issue of state effi­ciency and pro­ductiv­ity, bear­ing in mind that, des­pite all the debates and com­mis­sions on this sub­ject, no pro­gress has been made

In the end, we can see that the budget­ary con­straint will return, and that pub­lic defi­cits will have to be reduced where­as the spon­tan­eous tend­ency would be to main­tain or increase them. None of the three pos­sible aven­ues – increas­ing taxes, reform­ing pen­sion or increas­ing the pro­ductiv­ity of the state – is easy to imple­ment. But if they are not imple­men­ted, the choice is between allow­ing a debt crisis to take hold or not increas­ing the use­ful and effi­cient part of pub­lic spending.