Considerations on public debt
French economist, Professor at ESCP Business School
By replacing corporate debt, the economic support policies linked to COVID-19 have sent public debt levels through the roof globally. According to the IMF, global public debt should increase from 83% of GDP at the end of 2019 to 100% at the end of 2021. At that time, this ratio is expected to reach 119% in France, 158% in Italy and… 264% in Japan. Yet, many of the comments brought about by this explosion are absurd.
FOUR MISCONCEPTIONS ARE OFTEN SPREAD ABOUT PUBLIC DEBT.
The first is that it constitutes a burden that one generation transfers to the next. However, as early as the 18th century, Jean-François Melon demonstrated the approximative nature of such a claim. Melon, the secretary of the famous John Law at the time when the latter was propounding his public debt monetisation policy, sought to justify himself after the policy’s failure. He gave his view on what happened in his Essai politique sur le commerce (Political essay on trade) where he declared:
“THROUGH PUBLIC DEBT, THE COUNTRY IS LENDING TO ITSELF.”
He insists on the fact that public debt does not effect a transfer from one generation to another but rather from one social group, taxpayers, to another, the holders of public securities, who receive the interest.
The second misconception is that the repayment of debt presents a threat to public finances. Some therefore suggest issuing perpetual debt, so that it will never have to be repaid. However, it just so happens that, in practice, public debt is already perpetual. Indeed, governments do little more than pay interest. Since the beginning of the 19th century, no entry has been made in a government’s budget for the repayment of its debt. Each time a loan comes to maturity, it is immediately replaced.
The third misconception about public debt is that a precipitous rise in interest rates would constitute a threat; after all, the government’s concrete and formal commitment is to pay interest. The increasing scarcity of potential lenders would generate this rise in rates and would restrict the opportunities for governments to borrow. However, every modern economy has a central bank acting as lender as a last resort. As a result, banks have no problem buying debt that they can subsequently dispose of by selling it back to central banks – and they do so without limit. The effective interest rate and the amount of debt held by private players ultimately depend on the action of the central bank. Incidentally, the status of the US central bank, the Federal Reserve, is explicitly defined in its mission:
“Maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Though independent, central banks now maintain very low rates with the clear aim of alleviating the cost of interest for governments. In addition, as the central bank transfers back to the government the debt interest that the latter pays to the former, the portion of public debt owned by the central bank is free, which systematically reduces the average interest rate paid by the government. The situation in Japan presents an illustrative example of this. According to the OECD, its public debt/GDP ratio stood at 226% in 2019. The Japanese government quite calmly considers that this ratio will reach 600% in 2060. Its insouciance can be attributed to the fact that its net interest costs amounted to almost zero in 2019, thanks to an ultra-accommodating monetary policy and half of public debt being owned by the country’s central bank.
Finally, the fourth misconception is that there would be a division between good debt and bad debt.
Good public debt would finance investment; bad public debt would finance operations. This division makes little sense: it is based on taking the thinking behind private debt and applying it to public debt. It assumes that public investment spending prepares for the future, whilst public operational spending sacrifices the future for the present. However, it is easy to see that the salary of a researcher, whose work will lead to technical progress and therefore more growth, is operational spending, whilst the construction of a road leading nowhere corresponds to investment spending…
Nevertheless, the idea of good and bad debt should be detailed further because, in certain conditions, it should guide fiscal policy. Incidentally, our ancestors had identified the problem.
For a long time, religious authorities considered that remunerating a loan was tantamount to usury.
Their reasoning became more refined over time, to the extent that in the 13th century, Saint Thomas Aquinas could write:
“He who lends money transfers the ownership of the money to the borrower. Hence the borrower holds the money at his own risk and is bound to pay it all back: wherefore the lender must not exact more. On the other hand he that entrusts his money to a merchant or craftsman so as to form a kind of society, does not transfer the ownership of his money to them, for it remains his, so that at his risk the merchant speculates with it, or the craftsman uses it for his craft, and consequently he may lawfully demand as something belonging to him, part of the profits derived from his money.”
The nascent political economy then distinguished between two types of loan: on the one hand, there were “commercial” loans, also known as “production loans”, which financed investments and the emergence of future wealth, creating something on which to pay interest; on the other hand, there were loans aimed at helping those in difficulty, called “consumer loans”, which follow the same line of thinking as donations and should therefore be free.
The modern materialisation of Saint Thomas Aquinas reflections leads to the following affirmation: private debt is justified when financing investment that brings a structural improvement to growth, whilst public debt is justified in response to cyclical hazards, ensuring collective solidarity with economic sectors in difficulty due to cyclical fluctuations.
European treaties are based on these principles, the “Treaty on stability, coordination and governance in particular.”
THIS TREATY STIPULATES:
The budgetary position of the general government of a Contracting Party shall be balanced or in surplus; [this] rule shall be deemed to be respected if the annual structural balance of the general government [falls within] a lower limit of a structural deficit of 0,5 % of the gross domestic product at market prices.
It confirms the distinction between a “good deficit” – the circumstantial deficit, which appears when growth is struggling and disappears when growth is sustained – and a “bad deficit” – the structural deficit, which is independent of the cycle and remains no matter the circumstances.
What is worrying today is that we are moving away from this scheme, which is not without negative consequences. The first of these consequences relates to equality between supply and demand. Any public expenditure that is not financed by a tax on private spending increases demand. If this increase lasts, it will lead to one of two situations: an external contribution, that is, a deepening trade deficit, or the opportunity for the production system to increase its prices, that is, a boost to inflation.
The second negative consequence relates to an increase in public debt generating negative expectations for private players.
First, the instinct to save in order to prepare for an uncertain financial future brought about by the accumulation of debt leads to an increase in asset prices – property bubbles might be the most obvious materialisation of this phenomenon. This is what economists call “Ricardian equivalence”.
Second, these negative expectations erode the credibility of the currency.
Countries (like Lebanon) that see their currencies disappear in favour of the dollar because of a surge in public debt are rare. Nevertheless, we are witnessing a resurgence of gold, which remains the ultimate monetary recourse in the collective unconscious, a resurgence underlined by the soaring price of this precious metal.
All this to say that it is time to put an end to the “no matter the cost”, even if the cessation of payments of the government is not on the agenda.