This is my translation of a Commentary on Current Affairs written by François Ecalle on the French blog Fipeco, devoted to analyses of public finance and the economy in France.
In part I, Ecalle discussed how one might understand public debt. Here, he explains why public debt cannot increase ceaselessly and discusses the stabilizing of the debt-to-GDP ratio as a necessary (though not sufficient) condition for debt sustainability.
This is the second part of my translation of Ecalle’s article.
My thanks to François Ecalle for permission to publish this translation on my blog.
French article by François Ecalle
English translation by Urmila Nair.
Date of publication: November 11, 2020.
To view the original French article, click HERE
The Translation, part II
(A) The traditional analysis of the limits of public debt
(1) Excessive debt can lead to a crisis
A State that has a deficit—France, for example, for the last 45 years—repays its debts by borrowing the amounts necessary for the repayment1. Additionally, the State has to borrow in order to finance the deficit of the current year.
Public debt cannot increase indefinitely because the State’s creditors would eventually begin to doubt its ability to borrow sufficiently so as to continue repaying older debts while financing the deficit. Under such conditions, creditors would consider that they are running a risk by continuing to buy government debt. They would add a significant “risk premium” to the stipulated interest rate if they were to continue buying that debt. This increase in the interest rate would only aggravate the deficit and the debt, which in turn would reinforce creditors’ fears.
The risk premium can thus keep increasing, and the debt could then spiral out of control. Some creditors may refuse to buy up the debt even at very high interest rates. In such a case, the State, unable to repay its debts or to pay the excess of its expenditure over its revenue, would have to balance its revenue and expenditure immediately, by increasing taxes and/or cutting expenditure.
A State close to default generally calls on international institutions that play the role of lender of last resort, like the International Monetary Fund (IMF) or the European Stability Mechanism (ESM) in the euro area. The latter’s financial aid is not unlimited and comes with strings attached, the main requirement being that measures be implemented to balance public accounts, measures that are often painful for the population and that translate into a loss of sovereignty. These measures are, for the most part, based on the power to levy taxes and to earmark the resulting funds for expenditure voted on by Parliament.
The creditors of a given State may agree to a restructuration of the debt they are owed, by deferring the repayment of the principal and/or reducing the interest rate. They may thus continue financing the State if the latter is able to convince them that this would be less costly than the complete loss of the credit they had extended. It is very difficult to predict the outcome of such negotiations or the severity of the remedial measures imposed on the defaulting State on the one hand, and the creditors’ losses on the other. Furthermore, these losses are largely passed on by the creditors (banks, insurance companies, etc.) to their customers. Since financial institutions within a country often hold a great deal of the latter’s sovereign bonds, the households of the country may often suffer greatly.
(2) The capacity to stabilize debt is a necessary condition for debt sustainability
Public debt thus cannot increase indefinitely. Nevertheless, it is impossible to determine precisely the debt threshold beyond which a crisis of public finance would be triggered. This is because this threshold would depend on numerous parameters that are often not quantifiable and are specific to country and conjuncture.
Japan has no difficulty financing its deficit and repaying a public debt that is over 200% of its GDP since 20112. However, it holds considerable net assets in other countries. The overall position of all the economic agents of a country vis-à-vis the rest of the world is thus an essential parameter.
The relevance and credibility of the economic policy pursued are also essential parameters, as is the capacity to increase taxes or to reduce public expenditure if necessary. The probable degree of solidarity from neighboring countries, particularly within an economic and monetary union, should also be taken into account. Finally, the State’s relative public debt situation with respect to that of comparable countries is also an important parameter.
Economists consider that public debt is “sustainable,” that is, that it does not risk leading to default or a similar situation, if the State is able to stabilize the debt-to-GDP ratio within a certain horizon3.
The capacity to stabilize the debt-to-GDP ratio to any level and within any horizon, and thus avoid the debt’s spiraling out of control, is the necessary condition for debt sustainability. However, this is not a sufficient condition: a debt that can be stabilized at 500% of GDP would not be sustainable because the State’s creditors would begin to worry long before the debt reached this level and would provoke a crisis by demanding a higher risk premium. The level to which the debt is stabilized is thus not insignificant: the higher this level, the greater the risk of a crisis. Yet it is impossible to determine a maximum level.
To be continued in On the limits of public debt, Part III
While this article simplifies matters by speaking of the “State,” public deficit and debt, in reality, are held by the government as a whole (the State, local authorities, the social security administration and non-commercial public bodies controlled by the State or by local authorities). ↩︎
This refers to the consolidated gross debt of national accounts, used by the OECD. (In case of France, this was 123% of GDP at the end of 2019.) ↩︎
The relevance of this ratio is due to the fact that GDP is an approximate measure of the tax base , and hence of the potential resources of the State. ↩︎