“Debt-xit”, or the mirage of debt cancellation

The urgency is not so much to cancel the debt as to ensure that States beef up their investments to support future growth.


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The coronavirus crisis has disrupted the budgetary situation of developed countries. On average, the additional debt will be 20 points of GDP, because to cushion the shock, large public deficits had to offset the forced increase in private savings. So far, everyone is in agreement. But what to do with this debt? The “budgetary hawks” are calling for austerity without delay. On the other hand, we are campaigning for this debt to be canceled (“Debt-xit”). In both cases, we act as if debt sustainability were a critical threshold problem. In fact, one could argue that, given the insignificant cost of debt, it would be useful to take on more debt provided it is used to finance productive investments.

There is no evidence that exceeding “critical” thresholds
reduce future growth or make debt unsustainable.

According to the most recent IMF estimates, fiscal measures associated with the coronavirus crisis will amount to 11.8 trillion dollars in 2020 in developed countries. States have lost tax revenue, increased their stabilization expenditure, granted direct aid and loan guarantees. As a result, public debt soared, rising on average from 105% of GDP in 2019 to 125% in 2020, an unprecedented level in history. For the euro zone, the ratio would drop from 84% to 101%. It’s been a long time since we crossed the ceiling of the Maastricht Treaty (60%). Now we exceed the Reinhart-Rogoff “critical” threshold (90%), and even the fateful limit of three-digit public debt. Under these conditions, it is legitimate to ask whether the room for maneuver to stabilize the cycle in the future is not thereby reduced or even whether the public investment choices are adequate. However, we are surprised by the obsession expressed by many about the level of indebtedness.

Contrary to an idea anchored in many minds, there is no empirical proof that exceeding the famous “critical” thresholds reduces future growth or makes debt unsustainable. The consequences of a high debt ratio depend on the circumstances that caused this indebtedness, the institutions (Japan, Argentina), the effectiveness of fiscal stabilization and the financing conditions. Last year, countries like Germany and France placed all their debt at negative rates. In general, interest rates accentuated their downward movement. The action of the central banks contributes to this to a large extent. The increase in their purchase programs has in fact created a space to allow States to place their new debt with private investors. In the euro zone, the share of public debt held by the Eurosystem reached a new high point.

The Treaty on the Functioning of the EU prohibits
the central bank to finance public deficits directly.

In recent times, in several European countries, and especially in France, a debate has arisen about the cancellation of the debt held by the central bank. In the euro zone, this would bring the public debt ratio down to 77% of GDP. The logic is roughly as follows. A state indebted to the central bank is somehow indebted to itself. Canceling this debt would only require a game of writing that would not harm anyone and would allow various advantages to be obtained: reducing the risk premium on public securities, reassuring voters worried about future tax increases, allowing new spending . Cancellation campaigners further argue that since citizens are not responsible for the health crisis, the associated debt is immoral. We are not far from presenting the debt as the tool for the enslavement of the “people” by “finance”. It can be predicted without much risk of error that more than one demagogue aspiring to win future elections will present this option as a miracle solution. Let’s call it the “Debt-xit”. It’s about as difficult to write and pronounce as it is to implement effectively.

There are indeed many reasons against debt cancellation. First there is a legal argument, which is not insignificant. The Treaty on the functioning of the EU (article 123) prohibits the central bank from directly financing public deficits. It is even one of the pillars of the euro zone. Even if the term debt cancellation does not appear in the Treaty, a waiver of debt by the ECB would necessarily be judged as a direct transfer to the States and would fall under the scope of this prohibition. When supporters of debt cancellation suggest that it would be enough to change the Treaty, there is reason to be dumbfounded. No EU country, it must be said, wants such a review.

It is difficult to see how a cancellation would improve
really the situation of public finances.

Moreover, it is difficult to see how a cancellation would really improve the situation of public finances. On the one hand, the States would save what they should have paid to the central bank (which will still have to record a loss on its balance sheet). On the other hand, they would lose what they would have obtained in the form of seigniorage with the profits of the ECB. The operation is at best neutral from the point of view of flows of State expenditure and revenue. In the end, the promoters of debt cancellation come to join the austerity supporters (to whom they are generally diametrically opposed on the political spectrum): a high level of debt is presumed to be bad in itself beyond a certain threshold, some judging that it should be reduced by canceling the debt, others by budgetary consolidation.

There is also reason to question the consequences of debt cancellation for the future conduct of monetary policy. Why would the central bank continue to buy government securities if, after a certain time or a certain level, these securities are deemed to be null and void? QE is not intended to be extended indefinitely, but it goes without saying that, without the regular (APP) or specific (PEPP) purchase programs of the ECB, the financial conditions of the euro zone would not have not stabilized so quickly. Debt cancellation may also constrain central bank actions during monetary policy normalization.

Debt sustainability cannot be reduced to an immutable limit.

In short, we must call a cancellation of public debt by its real name, namely a sovereign default. We can pretend that it is not serious because it is done in a closed circuit between different State agencies, but that remains a defect. Who can believe that this would leave the capital markets indifferent? Who can also guarantee that the operation would never be repeated or extended to other holders of public debt, at the risk of destabilizing the financial sector? Instead of a reduction in the risk premium, the opposite could happen.

The only interest of this debate on the cancellation of public debts is to highlight how much the budgetary paradigm which governed the creation of the euro has become obsolete as the structures of the economy have changed, in particular the rate regime . Debt sustainability is not reducible to an immutable limit, especially when this limit relates a stock with high inertia to a flow subject to the vagaries of the cycle. High indebtedness can generate multiple equilibria, some pointing to stability, others to default, without it being possible to deduce an appropriate level. The euro zone has given many examples of this over the past decade. To analyze fiscal sustainability, it is less the debt that should be the focus of attention than the evolution of public expenditure and debt service. Borrowing rates fell for a long time, making it easier for States to refinance. The urgency is not so much to cancel the debt or to reduce the deficits by forced march as to ensure that the States take advantage of it to beef up investments capable of increasing the potential for future growth, for example in education. and infrastructure.

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