Given that the world economy is currently humming along, and major powers are not at war, current debt-to-GDP ratios are surprisingly high. They are being driven up by elections and the political competition they entail: to attract voters, political parties, particularly those on the far left and far right, often make extravagant promises about increases in social welfare spending and tax cuts. Incumbent governments may feel forced to match such policies, at least partially, at the cost of prudent fiscal management.
Large levels of public debt can also make for good politics. They make it difficult for new left-of-centre governments to raise spending on social welfare but they also make it difficult for new right-of-centre governments to cut taxes. Politicians of different hues can tie the hands of their successors in this way, making it difficult to lower public borrowing.
It is, of course, impossible to end public borrowing altogether. Public debt plays an important role in the economy. It represents a low-risk asset for investors and is thus essential for pension funds, insurance companies and private investors. Nevertheless, excessive public debt can create the risk of potential defaults. That is a key concern at present.
How will this episode of soaring public debt end? Historically, such high levels of debt have been reduced through a combination of four different factors.
First, economic growth: stronger growth boosts tax revenues and reduces the need for social welfare spending. This factor helped reduce the high public debt in the wake of World War II. In the current environment, however, it is difficult to see how growth could be boosted further.
Second, financial regulation: by requiring financial institutions to hold large amounts of public debt, the government can artificially lower the cost of borrowing. This approach, used in the 1950s and 60s, effectively taxes the financial system but runs contrary to the concept of an open and competitive international financial system.
Third, inflation: this is best thought of as an implicit default. High inflation pushes up wages and prices, increasing the tax base and making it easier to service debt. The hyperinflation experienced by Germany in the early 1920s is often cited as an example of how debts can be wiped out by inflation. However, this requires an unexpected burst of inflation. Otherwise, market participants will demand higher interest rates in anticipation of higher inflation and that would ultimately worsen the debt servicing burden. With information about inflation published monthly, and with financial markets alert to the risk of rising inflation and central banks seeking to achieve inflation targets of 2%, an unexpected surge in inflation is unlikely.
Fourth, explicit default: this option is unpalatable, often leading to a crisis, damaging reputations and making future borrowing more expensive and more difficult. With the other three options closed, avoiding an explicit default requires years of prudent fiscal policy to lower the mountain of debt. Whether politicians have the required resolve is doubtful.
Some commentators argue that the risks are exaggerated. But while some countries – such as Japan – have been able to service very large levels of public debt without difficulty, they remain vulnerable to potential crises. Economists worry about crises of confidence, which follow a simple dynamic.
Market participants will buy bonds from a highly indebted government if they think that they will be repaid in full when the bond matures. The government can issue new bonds – roll over the debt – and use the proceeds to pay the initial bondholders. However, if market participants suddenly doubt the government’s ability to roll over the debt in the future, they may withdraw from the market, causing interest rates to spike. This type of confidence crisis ended Liz Truss’s political career.
Large levels of public debt can make markets extremely sensitive to changing perceptions – whether warranted or not – about future economic conditions. Sentiment can shift rapidly. As the eminent late German economist Rudiger Dornbusch observed: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”
Investors in public debt must be mindful of this risk.
