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.
In part II, he explained why public debt cannot increase ceaselessly and discussed how the stabilizing of the debt-to-GDP ratio is a necessary (though not sufficient) condition for debt sustainability.
In part III, he discussed the formula for a debt-stabilizing primary balance and the limits to a stable public debt.
Here, in this fourth part, Ecalle discusses a situation in which the interest rate on public debt is lower than the GDP growth rate, this being the present situation in the euro area and France.
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 IV
(B) The limits of public debt when the interest rate is lower than the GDP growth rate
(1) Public debt then seems permanently sustainable.
If the apparent or implicit interest rate is less than the GDP growth rate, the stabilizing primary balance is a deficit (cf. the equation discussed in Part III). This is greater when the public debt is higher. The equation also signifies that a very high, indefinitely maintained primary deficit can always allow debt stabilization to a level that may be represented as:
Dp / (g – i)
Dp = primary deficit
g = GDP growth rate
i = implicit or apparent interest rate
(Cf. the discussion of i in footnote 1 in Part III and footnote 3 in Part I.)
Thus, for instance, if Dp is maintained at 5% of GDP, and if (g – i) remains at 0.02, then the public debt is stabilized at 250% of GDP.
The apparent or implicit interest rate of public debt, i, depends not only on the interest rates on loans issued in the present—which are today close to zero—but also on the interest rates on loans issued in the past and not yet repaid. This imparts a great deal of inertia to this rate. In France, i has been reducing slowly since the creation of the euro area. It remained at 1.5% in 2019 and could continue to decline for several years in countries of the euro area because the interest rates on new loans will probably remain close to zero if the risk prime does not increase too much. Indeed, the European Central Bank will probably maintain low interest rates. Savings will likely remain significant in the world at large, with people aiming to avoid risk; investment may not increase, which would limit the rise in long-term interest rates.
When a central bank raises its key interest rates, the implicit or apparent interest rate on public debt will increase, but only slowly. Even if the post-crisis growth potential is weak, it is likely that the implicit or apparent interest rate of public debt will remain lower than the nominal GDP growth rate in the years that follow. Public debt would thus seem to be permanently sustainable.
(2) Nevertheless, it is not certain that the interest rate on public debt will continue to remain lower than the growth rate.
The outlook for interest and growth rate is always a matter of uncertainty, and the crisis only strengthens this. One cannot, therefore, exclude a return to a situation in which the apparent or implicit interest rate on public debt is greater than the GDP growth rate, unlikely though this may be the coming years.
The current crisis shows us, in particular, that the GDP growth rate could well be far weaker than the interest rate on public debt—not because potential growth and its usual determinants (technical progress and so forth) are weak, but because governments prohibit companies from producing, for health and other reasons. New shocks of this type cannot be excluded.
If the interest rate on public debt rises above the GDP growth rate, whether permanently or on an average over several years, taking into consideration new shocks, then a primary surplus would be required. And this surplus would have to be much larger than before the current crisis in order to stabilize the debt, which could be very difficult to achieve.