Public debt – Private debt: the real heart of the matter is not where we think

Public debt is evil. This is the kind of statement we often see in the press, but it is wrong.

If we are going to be concerned about excessive debt levels, we should worry more about the private sector’s debt: it is this private debt, and in particular household debt, that lay at the root of the 2007 crisis, and not public debt that had already been cut back before the crisis. Ten years later, private debt remains high, especially in Europe, and this restricts private sector players’ ability to adjust.

But before we look at private debt, let’s take a look at the issue of public debt, where we can make a number of observations:

1 – The main role of public debt is that it allows wealth to be transferred to a date in the future, while restricting risk. At the end of the 1990s and at the close of Bill Clinton’s second term in the US, when some onlookers thought public debt was drying up, we could legitimately raise the question of the role of long-term savings products, particularly life insurance policies and pension funds. Public debt acts as a risk-free asset and plays a vital role in stabilizing the financial system. A private asset cannot fulfil the role of a risk-free asset as only the State has tax-raising powers.
(For those who are interested, Paul Samuelson published a paper in 1958 outlining a striking model, which gives greater insight into this concept and the importance of risk-free public debt. For further details, click here).

2 – Public debt must serve to absorb economic shocks. Public debt balances out the impact of shocks over time and avoids economies having to fully cushion them in one go. The impact of a shock is therefore spread out over time, avoiding drastic recessions and excessive unemployment. The 2009/2010 stimulus helped curb the increase in unemployment and limited the extent of the recession.

Aristotle’s Economics already mentioned this notion that public debt has a role in smoothing out impacts over time. If there is no public debt that can share out risk over time, then households and businesses must immediately adjust their demand conditions or their production conditions to the new context, which can lead to excessive volatility in economic activity, with the risk of overly sluggish growth in the long term and a lasting increase in unemployment and under-employment. This type of situation is clearly not beneficial.

3 – The argument often used is that public debt will hamper “our grandchildren” in the future and the press inundates us with figures to prove it: this is dramatic but not convincing. Public debt smoothes out growth volatility, thereby reducing the risk of an excessively dramatic and very long recession (see point 2). It steadies economic activity on a growth trend that also enables future generations to enhance their wealth. And as a large portion of public debt is held locally, coupons paid on debt will also help the next generations put up with the situation. Japanese public debt stands at 240% of GDP, yet this does not seem to be a major source of concern.

4 – The difficulty in assessing public debt is that we do not know what the right amount really is. A certain degree of public debt is broadly accepted for the reasons mentioned above, but at what point do we decide that it has reached excessive levels? We simply don’t know. In 2010, Carmen Reinhart and Ken Rogoff suggested that public debt exceeding a threshold of 90% of GDP would severely restrict growth, and neatly filled in two major gaps in economic theory: the first by defining a threshold above which public debt is excessive, and the second as they bear out the austerity policies sought by Germany for the euro area.

Unfortunately, this 90% threshold does not exist. Calculations were not reliable and we have to start all over again.

5 – The problem with public debt is that excessive levels curb leeway on economic policy. The real crux of the matter lies here, which is why it is important to proceed with caution. Economic policy must always be able to adjust to deal with economic shocks, and this explains why austerity policies must be implemented when the economy is buoyant, not when it all goes haywire, which is what tends to happen. This is also why the idea of a special fund to manage French public finances is absurd. If revenue is excessive, it is because growth is strong and it is high time that public finances were better managed in order to regain the flexibility that will be needed when the hard times come, as they inevitable always do.

Philippe Waechter – Chief economist – Natixis Asset Management