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Has public debt in the developed world become fundamentally unmanageable? The question is far from outlandish. Recent debt numbers starkly underline how far we have moved beyond the ancient public finance paradigm whereby debt was racked up in wars and paid down in peacetime.
Consider, first, the US. While the ratio of debt to GDP in the world’s biggest economy shrank from 106 per cent in 1946 to 21.6 per cent in 1990-91, it has since lurched back up to almost 100 per cent thanks to, among other things, the financial crisis and Covid-19.
The discomfiting fact is that in the US, as elsewhere, economic growth, relative to the decades after the second world war, is lower, interest rates are higher and budget deficits are wider. The Congressional Budget Office now projects a rise in the debt ratio to a clearly unsustainable 156 per cent of GDP by 2055, which potentially undermines the role of US Treasuries as the essential anchor in global finance.
Meantime, in Europe, the IMF is predicting a doubling of the average country’s public debt over the next 15 years in the absence of policy change, leading to higher borrowing costs, lower growth and financial instability. All of which amounts to an intolerable burden on future generations.
There are, of course, time-honoured ways of bringing down the debt-to-GDP ratio. Running a primary budget surplus before interest is an essential policy tool. Economic growth, which boosts tax revenues and reduces cyclical spending, obviously helps. And keeping real interest rates below the rate of growth is a very powerful debt-reduction mechanism. Informal default via inflation also plays a crucial part, as does financial repression, whereby governments force investors to buy their IOUs at below market rates.
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The postwar experience of the UK provides a case study of how these factors interact. The country’s debt-to-GDP ratio went from more than 250 per cent in 1946 to just 42 per cent three decades later. In a seminal piece of research, Barry Eichengreen and Rui Esteves show that for most of the 1946 to 1955 debt consolidation episode, the UK ran consistent, large primary budget surpluses despite the Labour government’s huge expansion of the welfare state.
Yet the largest contribution to debt reduction came from inflation, which was responsible for more than 80 per cent of the debt consolidation over the period. That said, from 1955, fiscal discipline and economic growth did most of the work — surprisingly given Britain’s record at the time for economic incompetence — because the contribution of consumer price inflation, which peaked at 24 per cent in 1975, was neutralised by rocketing interest rates.
The politics of such a spectacular debt reduction have been characterised as a distributional struggle for income, turning on the question of whether to bleed the rentier, sweat the worker or leech the entrepreneur through penal taxes. Yet in the real world, these categories overlap, not least because today’s rentiers include millions of pension scheme members.
That struggle today is marked increasingly by extraordinary pressure to extend largesse to cope with the ageing of the population, with its costly implications for pensions, healthcare and the rest. Then add in the bill for geopolitical frictions and climate change.
Could a huge productivity-induced boost to growth from artificial intelligence come to the rescue? In a recent paper for Deutsche Bank Research Institute, Matthew Luzzetti and colleagues take the midpoint of a variety of leading economists’ estimates of such a boost and suggest that AI could lift productivity by 0.5 to 0.7 per cent a year. But, they conclude, the resulting growth impulse is more likely to slow the upward creep in debt than lead to a sharp reversal in the trajectory. So no deus ex machina there.
In this world where growth is increasingly debt dependent, political polarisation and populism create conflicting demands for more spending and less taxation. Meanwhile, central banks have added a ratchet with their penchant for putting safety nets under plunging markets while failing to curb market euphoria. And their inflation-targeting remit makes it harder now to inflate debt away. Inflation has to be unanticipated if its impact is not to be neutralised by rising interest rates. So this solution is, in effect, dependent on central bank cock-ups. Failing that, on politically ordained central bank financing of public debt.
Financial repression is also problematic in a more sophisticated financial world where the exchange controls necessary to support the repressive regime would almost certainly prove porous.
It follows that harsh bond market discipline, not political will, holds the key to debt consolidation. That points, in due course, to financial crises and political instability. The Swedish economist Anders Aslund feels the current situation is redolent of 1929. Even if you think his view extreme, it is hard to disagree with him that this cannot end well.
john.plender@ft.com
