For many, public debt is currently the number one enemy of economic recovery in Europe. Debates on how to reduce this debt are common. Five methods are often cited:
– Economic growth: more growth means more tax revenue. If tax rates remain unchanged, a larger tax base will generate more tax revenue. More wealth therefore means more tax revenue, and more tax revenue means more resources to repay the debt.
– Fiscal adjustment or austerity: in theory, raising taxes or cutting spending (austerity) increases government revenue and therefore allows a larger portion of the debt to be repaid. However, this fiscal adjustment must not undermine growth to such an extent that it has the opposite effect on government revenues, which is the subject of much debate at present.
– Defaulting on part or all of the debt – Restructuring the debt: see our previous insight on this subject, « What does sovereign debt restructuring really mean? » It should be noted that a partial default is not « free »; it sends a signal of irresponsibility about the government (that it is not capable of managing its finances) and therefore undermines the credibility of the government in question: who will be willing to lend to someone who has not repaid their debts in the past?
– Surprise inflation: as we discussed last week in this insight, inflation reduces the weight of debt. The debate over whether inflation is anticipated or not and its effects is too complex to be addressed here. Suffice it to say that inflation that is not anticipated by economic agents is expected to have a greater impact on government revenues (via the mechanisms at work in the economy as a whole) than anticipated inflation.
– Financial repression: Financial repression consists of implicitly or explicitly directing demand from financial institutions towards government debt. In other words, these institutions are forced, more or less explicitly, to buy government securities, sometimes on terms that may even be advantageous to the government. Even in the absence of specific purchase conditions, strong demand for Treasury bonds artificially lowers interest rates on debt and therefore the government’s borrowing costs, which ultimately has a beneficial effect on government debt.
Julien P.
Notes:
For further reading, see Reinhart and Rogoff’s article « Financial and Sovereign Debt Crises: some lessons learned and those forgotten, » which inspired this insight.
