The True Cost of Public Debt

Thomas Philippon
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The social cost of debt is probably low and in countries where growth exceeds the interest rate, there is no reason to maintain a primary surplus.
By Thomas Philippon
Public debt in developed countries soared during the 2008 financial crisis and the 2011-2012 Eurozone crisis. The debt-to-GDP ratio is around 87% on average in the euro area, but is close to 100% in France and Spain and over 130% in Italy. For ten years, these countries have made considerable efforts to reduce their deficits and to lower their debts. New research presented by Olivier Blanchard at the annual conference of the American Economic Association, of which he is the outgoing president, however, calls into question the conventional analysis of the dynamics of public debts.

The classical theory is based on fairly simple assumptions. The first important point in this regard is that the repayment horizon of public debt, unlike private debt, is not finite. A household that borrows 1,000 euros must repay them in a few years. Even mortgages must be repaid in less than 20 years, on average. A state borrowing 1 billion euros, on the other hand, does not need to repay them in a finite period of time. As long as the debt-to-GDP ratio remains at a reasonable level, maturing debt can simply be replaced by new one.

Stabilize the debt-to-GDP ratio
The second important point is the stability of the debt-to-GDP ratio. In classical theory, the interest rate is higher than the growth rate. For example, if the (nominal) interest rate is 5% and the (nominal) growth rate is 3%, the government must achieve a 2% primary surplus to stabilize the debt-to-GDP ratio. Without a primary surplus, the stock of debt is expected to increase by 5% annually to pay interest. This growth would be greater than that of GDP and therefore unsustainable.

It is this second point that Olivier Blanchard is challenging. The former chief economist of the International Monetary Fund (IMF) notes that the 10-year US rate of around 3%, is 1 point lower than the nominal growth forecast of 4% (2% real growth, 2% inflation). The difference is even stronger in the United Kingdom and in the euro zone (2 points).

Even more surprisingly, Blanchard shows that this situation is not unusual. Since the Second World War, the growth rate has averaged 2% higher than the effective interest rate. In this situation, even with a primary deficit of 1%, the debt-to-GDP ratio would decline by 1% per year. In other words, the state would never need to repay its debts. Should we take advantage of this to let deficits slip and accumulate more debt? Not necessarily, because public debt could divert savings from private investment. But, again, low rates suggest that these investments are not very productive. Low rates suggest that a (very) slow adjustment is both feasible and socially desirable.

Primary surplus
What can be concluded from this brilliant and thought-provoking analysis? That the social cost of debt is probably low and that in countries where growth exceeds the interest rate, there is no reason to maintain a primary surplus. It is better to promote public investment or lower taxes. This is certainly the case for the euro area as a whole, but not in each country. In Italy, unfortunately, the growth rate is not higher than the interest rate.

Blanchard's conclusions, however, do not absolve governments of their responsibilities and certainly do not excuse them from critically analyzing the quality of expenditures. Macroeconomic conditions indicate that the level of debt should not be an obstacle to public investment, but this does not justify the hiring of new public sector workers or tax gifts to the rich. There is no free lunch, but there is time to fund public investments.
Thomas Philippon is a Professor of Finance.

This article first appeared in Les Echos on January 10, 2019.