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

Patrick Artus
Head Economist at Natixis
Key takeaways
  • A succession of financial crises has led to a very rapid increase in public debt – 116% of GDP in France.
  • Despite the efforts of central banks, it was not possible to bring inflation down after the 2008 crisis.
  • Countries have thus taken advantage of the opportunity to take on debt at very low cost.
  • High energy prices are likely to continue, partly due to the war between Ukraine and Russia.
  • Increasing the tax burden may be one of the only viable solutions to address public deficits.

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.

The failure to recover from inflation

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.

Energy will remain expensive

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.

Rising interest rates, falling GDP

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.

Solutions for reducing the public 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.

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