Dedramatising debt

Post-pandemic recovery and the green transition—and Europe’s competitiveness—depend on investment financed by joint borrowing.

The Covid-19 recession in 2020 resulted in a drop in gross domestic product, a rise in public deficits and consequently a public debt hike. Today fear of excessive debt and rising inflation is haunting us again. It can be even more frightening if we take into perspective a longer period. Over the past 15 years, the average debt/GDP ratio has risen from 70 to 130 per cent in member countries of the Organisation for Economic Co-operation and Development, benefiting from supportive monetary policies.

This trend raises a whole series of concerns and questions—not confined to the debt hawks. Are there at least semi-objective limits to government debt and what should the benchmarks be? Should we take into account the origins of debt, for example treating investment differently from current expenditures? Under what conditions are public debts sustainable today in OECD countries and to what extent are there still additional margins?

Most would agree that in the long term the stabilisation of debt ratios is desirable but it is unclear on what terms. Should this be achieved through limiting deficits (restraining spending or increasing taxes), accelerating inflation (and so the devaluation of a nominal debt figure) or stimulating growth through investment (and a little more public debt temporarily)? There have also been proposals for cancelling part of the debt—that held by the central bank, for example.

Measuring the risks

Make no mistake: excessive public debt can be dangerous and the related risks have to be measured using a number of indicators. Most often, the sustainability of public finances is measured by the debt-to-GDP ratio, and this is the case within the economic and monetary union (the ‘Maastricht criteria’). For most of the time, however, the debt-service ratio (determined by the prevailing interest rate) matters more for economic-policy navigation—except when market sentiment deteriorates and it becomes too late to pay attention to debt/GDP anyway.

At the same time, it is not sufficient to monitor public debt. For overall fragility or sustainability, the size of private debt has to be factored in too. Overlooking this was a grave error before 2008 (as in many previous debt crises). Unorthodox solutions can be used sometimes—for instance, the debt reduction for Poland in 1991—but debt relief is unorthodox precisely because it cannot be turned into a mainstream solution.

Some of the concerns manifest in current debt debates make a lot of sense, but only from the perspective of a small and open economy. The logic of larger blocs can be different. For Europe as a whole, the overall problem is not the size of public debt. Rather, it is the lack of adequate financial structures at European Union level, which engendered vulnerability in previous crises and is still not solved.

Joint borrowing

Joint issuance of public debt among eurozone countries, as now piloted in the context of the Covid-19 recession, helps reduce risks and enhance resilience. A very good example is SURE, the employment-support measure, powered by joint borrowing, which resolved the collective-action dilemma member states would otherwise have faced in borrowing €100 billion to save 3-4 million jobs.

Despite the recovery fund Next Generation EU, however, the eurozone fiscal stance risks being restrictive from 2022. If we are serious about transforming our economies and making them sustainable, we have no other option than to invest and to do so in a smart way. Due to the symmetrical recession triggered by the pandemic and the need to spur the green transition, the EU needs to reconsider its investment capacity—and, consequently, its borrowing capacity too. 

For a viable recovery and a transition to a more sustainable economic model, the inherited fiscal rules of the EU must be reformed—if they are not to remain sidelined for a very long time. Of the old rules, the 60 per cent debt/GDP ceiling appears most out of synch with reality and we need to ensure no government seeks to enforce it, through austerity, in the foreseeable future.

This is a difficult issue, since arbitrary debt ceilings have achieved totemic importance in some cases. In particular, Germany has a serious problem with its own constitutional arrangement (the schwarze Null), which has to be addressed to enjoy the freedom to pursue future-oriented economic policies.

Uneven capacity

The problem that has been looking for a solution for some time is the uneven fiscal capacity within the euro area. The crisis of a decade ago saw financial fragmentation and deepening asymmetry but the instrument invented to deal with these—the Macroeconomic Imbalances Procedure—did not even come close to tackling the challenge. As then, investment in peripheral countries is at risk of remaining depressed while there is no way to boost investment in surplus countries. The aggregate macroeconomic outcome is therefore suboptimal, to say the least.

Unless the inherited macroeconomic rulebook of economic and monetary union is reformed, with the investment capacity of European countries so constrained Europe puts itself into a long-term competitive disadvantage vis-à-vis the United States, Japan and others. Without fiscal policy supporting, monetary policy cannot defuse the built-in pro-cyclicality of the old Stability and Growth Pact.

Fiscal deficits have to be recognised as part of the solution in a recession and they may be instrumental in supporting productive investments in good times as well. Investment in social infrastructure and human resources expands GDP potential and should be considered a priority.

Besides, in times of crisis the automatic fiscal stabilisers (such as increased welfare spending) are behind rising deficits. These not only need to be sustained but they also partly need to be transferred to the EU level—as with borrowing capacity—for greater fiscal resilience.

In a broader context, fiscal sustainability in OECD countries is about more than just public debt. New initiatives among the G7 (and subsequently the G20) for a minimum level of corporate tax co-ordination, if this works out, may play an important role in protecting the tax base and keeping deficits and so debts under control.