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?
Issuing new “Covid money”
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.
Rising public 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).
Which policies are possible?
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
A debt crisis?
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.