Where does public debt come from and what should we do about it?

In 1973, at the time of the first fuel crisis, the pub­lic debt ratio in OECD (Organ­isa­tion for Eco­nom­ic Co-oper­a­tion and Devel­op­ment) coun­tries was 30% of GDP (36% in the US, 20% in France). Today, it rep­res­ents 98% of GDP in the United States and 116% in France. The suc­ces­sion of dif­fer­ent crises has led to a con­tinu­ous use of pub­lic defi­cits and expan­sion­ary fisc­al policies.  These crises include the oil crises of the 1970s and early 1980s, the hous­ing crisis of the early 1990s, the stock mar­ket crash of the early 2000s, the subprime crisis of 2008–2009, the Cov­id crisis of 2020 and the war in Ukraine.

So, the recent peri­od has been a peri­od of very rap­id increases in pub­lic debt. Let’s look at what happened.

After the subprime crisis, OECD coun­tries exper­i­enced a peri­od of very low infla­tion (1% on aver­age from 2008 to 2020 in the euro area), below the tar­gets set by cent­ral banks (2%). For insti­tu­tion­al reas­ons, the lat­ter have there­fore tried to raise infla­tion by using highly expan­sion­ary mon­et­ary policies: intro­duc­tion of zero or even neg­at­ive short-term interest rates or « Quant­it­at­ive Eas­ing », i.e., pur­chases of gov­ern­ment bonds by cent­ral banks, fin­anced by money creation.

How­ever, these mon­et­ary policies were not suc­cess­ful: infla­tion did not recov­er because the money cre­ated was used not to buy goods and ser­vices, but to buy fin­an­cial and real estate assets. This led to a sharp rise in the prices of these assets (cor­por­ate shares and real estate), in par­tic­u­lar bond prices: a sharp fall in long-term interest rates (10-year interest rates in the core coun­tries of the euro zone became negative).

All this has res­ul­ted in the dis­ap­pear­ance of the con­di­tions for the sus­tain­ab­il­ity of pub­lic debt. With interest rates well below growth rates, any pub­lic defi­cit is accept­able, any level of pub­lic debt is con­sist­ent with states’ solvency con­straints. It is there­fore easi­er to under­stand why pub­lic debt rates have ris­en sharply since 2008. States have simply taken advant­age of the pos­sib­il­ity offered to them to take on debt at a very low cost – and even at a neg­at­ive cost in some cases.

How­ever, today the situ­ation has changed. The end of the Cov­id crisis has led to a dra­mat­ic increase in demand for goods (elec­tron­ics, house­hold equip­ment), which has led to bot­tle­necks in the sup­ply of energy, raw mater­i­als, semi­con­duct­ors, and ship­ping. As a res­ult, high infla­tion developed and was amp­li­fied by the con­sequences of the war in Ukraine. Inter­rup­tion of nat­ur­al gas sup­plies from Rus­sia to Europe and a sharp rise in energy prices (elec­tri­city, nat­ur­al gas, coal), espe­cially in Europe.

High energy prices are here to stay. Repla­cing Rus­si­an nat­ur­al gas will take time, and bey­ond the energy trans­ition, this will lead to high energy prices – espe­cially in Europe – as we will have to bear the cost of the inter­mit­tency of renew­able energy production.

We must there­fore expect per­man­ently high energy prices and fur­ther increases in infla­tion caused by the increased bar­gain­ing power of employ­ees in labour mar­kets and the relo­ca­tion of stra­tegic pro­duc­tion. All this gen­er­ates an infla­tion­ary envir­on­ment, mainly in Europe, which com­pletely trans­forms the issue of mon­et­ary policies.

The Euro­zone faces the greatest chal­lenge. Fisc­al policy will be per­man­ently expan­sion­ary as gov­ern­ments seek to sup­port house­hold pur­chas­ing power, fin­ance the energy trans­ition, edu­ca­tion and health spend­ing and improve busi­ness com­pet­it­ive­ness in the face of rising energy prices.

It can there­fore be pre­dicted that the peri­od of low infla­tion – and con­sequently low interest rates – is well and truly over. We will now see the return of debt sus­tain­ab­il­ity con­straints: the sharp rise in real interest rates will force gov­ern­ments to reduce pub­lic defi­cits, main­tain­ing their fisc­al sustainability.

The peri­od of low infla­tion, and con­sequently low interest rates, is well and truly over.

Let’s take the example of France: in the low interest rate envir­on­ment, the sus­tain­ab­il­ity of the pub­lic debt was ensured with a primary pub­lic defi­cit (exclud­ing interest on the pub­lic debt) of around 3% of GDP. If the real interest rate returns to pos­it­ive ter­rit­ory – with the addi­tion of the very low level of pro­ductiv­ity gains – the primary pub­lic defi­cit will have to dis­ap­pear, which means a reduc­tion of 3 points of GDP in the deficit.

What are the means avail­able to reduce the pub­lic defi­cit by 3 points of GDP? It is a task that seems dif­fi­cult giv­en the increased need for pub­lic spend­ing in almost all areas: energy trans­ition, rein­dus­tri­al­isa­tion, health, edu­ca­tion, justice, mil­it­ary spend­ing… The only pos­sible way for­ward is to increase the retire­ment age in coun­tries where it is still early, such as France. But even if the employ­ment rate of 60–64-year-olds in France (35%) were to reach the level of coun­tries where it is highest (65%), we would only gain 1 point of GDP in terms of pub­lic defi­cit (74% in Ger­many, 77% in Sweden).

If lower­ing pub­lic spend­ing does not seem to be rel­ev­ant, what oth­er aven­ues remain? In the­ory, it would be pos­sible for cent­ral banks to fin­ance pub­lic spend­ing, which remains high because of the infla­tion­ary tax, by keep­ing interest rates below infla­tion. How­ever, we are now wit­ness­ing a sig­ni­fic­ant rise in interest rates and the dis­ap­pear­ance of this infla­tion­ary tax.

The only way to elim­in­ate pub­lic defi­cits is to increase the tax bur­den. This solu­tion might be unpop­u­lar, but it is in line with the obser­va­tion that the need for new pub­lic spend­ing is very high.