Public Debt Is At An 80-Year High. How Can Finance Ministers Tame It?

By Jordi Gual (IESE Business School)

The ratio of public debt to GDP in advanced economies was 112% this year, up from 104% in 2019, before the pandemic’s toll on economic activity brought on a dramatic spike. That peacetime figure is, remarkably, among the highest since way back in 1946, in the immediate wake of World War II.

A widespread issue

What’s more, the ratio for emerging economies hit an unprecedented 69% this year. All told, global public debt tripled between the mid-1970s and 2022, when it reached 92% of GDP.

How big a problem is the current debt level, which by all accounts is high by historic standards? And which measures might economic ministers put in place to alleviate it?

While the planet has been spared a military conflict on the scale of WWII, the current debt peak came about because governments gave huge amounts of money away during a global pandemic as they essentially provided insurance for an uninsurable event. And even though most governments have ended pandemic-related fiscal supports, their responses to food and energy price hikes have made the issue persist.

All of this coincides with debts that surged after the financial crisis (due to support for the population and private debts being made public) as well as the fact that democratic governments (in profligate countries, but also in the US and UK) have a hard time controlling spending and raising taxes, resulting in a tendency to be in deficit.

The potential consequences of high indebtedness are interwoven, and depend on responses by government leaders. Broadly speaking, though, as debt service gets more and more expensive, policies to restrict it result in increased taxation. Decreased spending is another consequence of restrictive policies, and can come about alongside or independent of higher taxes.

What’s worrisome about the current scenario is the gradual, sustained increase in public debt underpinning it. This could lead to a dangerous spiral of increased debt and costs that lands the economy in a full-blown crisis.

The situation is distinct from the 2008 financial crisis, which involved private debtors. Still, certain patterns are repeating themselves. For instance, the public debt challenge in the eurozone is compounded by having a single currency and 20 treasuries. And the moral hazard remains of profligate countries in the zone piggybacking on frugal ones.

Time-tested responses

In the past, central banks often relied on growth to rein in debt. The problem is that the burden of debt makes it hard to grow through consumption. Austerity measures are another response, but as the past 15 years have proven, even well-intentioned measures to achieve budgets in primary surplus can ignite fierce citizen backlash and entire populist movements.

Financial repression is a debt-taming action, undertaken by several governments after WWII, of controlling interest rates administratively. This cannot be done nowadays in free markets, but an alternative is leaving rates alone and buying government bonds via unorthodox monetary policy, thereby reducing government funding costs. Advanced economies are unlikely to resort to the restructuring and default option that Argentine has pursued. Finally, a too-tepid response to inflation spurred in part by debt invites in a cancerous threat to economic health.

Given the severity of the current debt situation, we can’t expect easy solutions or quick improvements. I foresee that to pay back debts governments will play the following game: central banks will keep inflation around 3 or 4%, a level at which the real value of debt diminishes. The banks will maintain interest rates at just around the same levels, resulting in a real interest rate around zero.

Whittling away at today’s unsustainable debt levels will take significantly longer than anyone would like. But keeping interest rates moderately high, spending cuts and tax increases that don’t cripple consumer spending and, hopefully, a steady cooling of inflation would be reason for cautious optimism among those taking the long view.

Jordi Gual is a professor of economics at IESE Business School.