The cancellation of public debt: a false solution and a real danger

11.17.2023 2 min
Published in Les Échos the 17th of November

Public debt has grown alarmingly in both advanced and emerging countries. Its rise was facilitated by the central banks’ policy of quantitative easing (with interest rates lower than growth rates and the purchase of public bonds) which hold around 30% of its current outstanding balance in the euro zone and have financed more than 60% of its growth since 2008. However, current interest rates have risen sharply, particularly given the return of inflation but also a certain normalisation of monetary policy. In France, interest on public debt will amount to more than 50 billion euros in 2023 and more than 70 billion in 2027.

The exit “from the top” of such a level of public debt is necessarily very restricted, given that in France the level of taxation on GDP is already one of the highest in the OECD countries. It is therefore a question of structurally improving the growth rate through reforms to increase both productivity gains and the available workforce. And to reallocate public spending – not exclusively that of the State – as efficiently as possible, while generating, without an austerity policy, a primary surplus (before payment of debt interest) of the budget.

Some, notably in France, are pushing the much more attractive, apparently easy and effortless, idea of ​​a total or partial cancellation of public debt held by central banks. Supposed to considerably alleviate the solvency constraints of public players, this cancellation is in reality not only prohibited by the euro zone treaties, but above all ineffective and dangerous for financial stability.

Let us focus on its real pointlessness, not always well understood. The accounts of central banks, most often subsidiaries of States, must be analysed once consolidated with those of States.

Moreover, their profit is paid in the form of dividends and thus directly contribute to the budget. If central banks agreed to cancel the bonds issued by the State which is their shareholder, this State would have to recapitalise the bank concerned, by issuing the same amount of public debt. Or, if it did not do so, thus apparently lowering the public debt to GDP ratio, it would have to consolidate with its own deficits or surpluses the recurring loss or shortfall thus imposed on the central bank. And even if central banks agreed to only be remunerated at an interest rate equal to zero on the public debts they hold, the state budgets would experience a shortfall of exactly the same amount. In short, from a budgetary point of view, it is a zero-sum game. Proceeding with such cancellations, however attractive it may seem, would in reality be completely pointless.

Vain, but not without danger! The announcement of such a decision would be very destabilising and the subsequent capacity of the State to finance its debt could be seriously compromised or dearly paid for in terms of risk premium. Especially since such an operation would amount to placing monetary policy completely under the controlof public authorities. And to render it ineffective in its control of monetary aggregates and in its fight against inflation. With obvious consequences for the disanchoring of expectations and the destructive risk of hyperinflation.

Finally, and to conclude with an absurd reasoning, if such a possibility existed, without risk and without pain, why have states not been allowed to develop deficits ad libitum for a long time, without spending limits? This would have relieved the woes of the world without any cost. Unfortunately, there is no magic money.

Olivier Klein
Managing Director Lazard Frères Bank
Professor of Economics and Finance at HEC