Public debt

7 How governments repay

Recall the debt dynamics equation, which reads:

\[\begin{align*} \text{Δ}b &= d + (r − g)b_{t − 1} &&(5) \end{align*}\]

This highlights three ways governments can prevent their debts from becoming unsustainable (that is, that they can prevent the debt-to-GDP ratio from rising explosively and spiraling out of control). Firstly, they can run primary surpluses and use the excess revenues to retire (that is, repay) outstanding debt. In other words, they can ensure that the deficit ratio, \(d\), is negative.

However, there are relatively few recent instances where governments have succeeded in running substantial surpluses for extended periods. One study found just three cases of countries that ran surpluses of 5% of GDP for 10 consecutive years.¹ When revenues rise, governments face pressure from voters to increase spending and not just retire debt. Economic shocks, from recessions to financial crises and pandemics, can throw the effort to maintain primary surpluses off course.

austerity

A policy where a government tries to improve its budgetary position in a recession by increasing its saving.

In addition, a sudden shift from deficit to surplus (for example, by undergoing a period of austerity) risks precipitating a recession by depressing aggregate demand. Efforts to reduce the debt-to-GDP ratio that end up only reducing GDP can be counterproductive even from the narrow standpoint of fiscal consolidation. Thus, euro area countries, having borrowed in response to the Global Financial Crisis of 2008–2009, sought to reduce those deficits starting in 2010 before recovery from recession was secure. The result was that the euro area slid back into recession starting in June 2011, causing the debt-to-GDP ratio to rise rather than fall.

For more details on the effects of austerity policies, see Section 14.6 of The Economy 1.0.

This points to a second way of stabilizing or reducing debt relative to GDP, through economic growth (\(g\)) that raises the denominator of the ratio. The sharp reduction in the U.S. debt-to-GDP ratio after the Second World War shown in Figure 2, like similar reductions in other high-income economies, was aided by fast economic growth from 1945 to 1975 (known in France as Les Trente Glorieuses, or the thirty glorious years).

Replicating that growth success today, unfortunately, is unlikely. In many countries, labor supply is growing more slowly. Productivity growth has slowed since the mid-1970s.

A third way of stabilizing or reducing the debt ratio is by keeping the interest rate on government debt securities (\(r\)) low. Governments do this by cultivating a reputation for repaying, so that investors will have no reason to demand a risk premium on top of the risk-free interest rate. Central banks can act as lenders and liquidity providers of last resort, limiting bond price volatility for which investors require additional compensation.

After the Second World War, policy makers also used statutory regulation to depress \(r\). In the U.S., they placed ceilings on the interest rates that banks were permitted to offer on time deposits. This encouraged depositors to shift into treasury securities, driving their prices up and yields down. Economists refer to these regulations and policies depressing \(r\) as ‘financial repression’.

Financial markets today are more lightly regulated, however, limiting scope for financial repression. International capital mobility is higher than after the Second World War, enabling investors faced with artificially low interest rates in one national market to shift their funds to another.

Light-touch regulation and international capital mobility also limit the scope for using inflation to reduce the value of the debt relative to GDP. Inflation might seem like a foolproof way of raising the denominator of the debt-to-GDP ratio. But if it leads to a commensurate increase in the cost of servicing that debt (in the nominal interest rate), then the government saves nothing. In countries such as Brazil, where the vast majority of public debt is either short term (maturing in a year or less) or indexed (where the contract specifies that payments rise one-to-one with inflation), there is little scope for inflating away the debt.