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.