Public Debt: A Tale of Two Worlds

Alexander Privitera

AGI Non-Resident Senior Fellow

Alexander Privitera a Geoeconomics Non-Resident Senior Fellow at AGI. He is a columnist at BRINK news and professor at Marconi University. He was previously Senior Policy Advisor at the European Banking Federation and was the head of European affairs at Commerzbank AG. He focuses primarily on Germany’s European policies and their impact on relations between the United States and Europe. Previously, Mr. Privitera was the Washington-based correspondent for the leading German news channel, N24. As a journalist, over the past two decades he has been posted to Berlin, Bonn, Brussels, and Rome. Mr. Privitera was born in Rome, Italy, and holds a degree in Political Science (International Relations and Economics) from La Sapienza University in Rome.

Ask a number of economists at which level public debt becomes dangerous and you will get many different answers. In the wake of the great financial crisis in 2007-8, Kenneth Rogoff and Carmen Reinhard thought it was when the debt-to-GDP ratio exceeds 100 percent. That sounded about right. Most experts and policymakers adopted their findings. Some of their underlying assumptions have been questioned since, but the core message has stuck.

Thus, it is not surprising that once the debt ratio crossed the 100 percent Rubicon in countries such as the United States and France, experts started to sound the alarm. Politicians, however, are a different story. On one side of the Atlantic, the political world has largely chosen to ignore the Cassandras from academia, fiscal watchdogs, and the International Monetary Fund. U.S. presidential candidates have been showering voters with a series of largely unfunded promises. Perhaps they still think that America can spend itself out of any problem thanks to its almost limitless ability to issue debt. Or, they simply think nobody seriously expects them to follow up on their promises. Regardless, given the poor record of officeholders of both parties in keeping public expenses in check, cracks are finally starting to appear among once sanguine bond investors.

Across the Atlantic, the picture has already evolved. After the spending splurge enacted in response to the COVID-induced economic emergency, European countries are increasingly tightening their belts. There, the problem is that this comes at a time of slowing economic activity. Policymakers are aware they could cause additional economic pain, and many are therefore trying to chart a middle course between the need to consolidate finances and the necessity to support weakening economies. Watch the contortions of the new British government in trying to reconcile the promise of higher levels of public investments and the need to save money, and you may be forgiven if tempted to believe someone is once again trying to have the cake and eat it too.

The new government in France has made a different choice, announcing shock therapy instead. It is trying to avoid its own Liz Truss moment when confidence among bondholders suddenly evaporates because of a self-defeating political fumble and funding public debt suddenly becomes much more expensive. Michel Barnier, the new technocratic prime minister, is determined to reassert the perception that France and Germany are joined at the hip as Europe’s true issuers of safe debt. The fact that funding costs in Paris and Berlin have started to diverge is causing senior French officials sleepless nights. Interest rates on public debt in France now exceed or are close to those of Spain, Portugal, and Greece, once infamous members of a club of shaky euro area countries put under international and European fiscal surveillance programs. To restore France’s public finances and credibility, Prime Minister Barnier is planning 60.6 billion euros (about 64 billion USD) in spending cuts. But French politics is no longer predictable. Barnier is a technocrat without an own majority in parliament, and his fate largely depends on the goodwill of the far-right populists of Marine Le Pen. She seems to believe that it is better for a technocrat like Barnier to inflict unavoidable pain on citizens, get them even angrier, and then pull the plug on the government once she can reap the political benefits.

Not surprisingly, Olivier Blanchard, former Chief Economist at the IMF, has warned that measures should be calibrated carefully. To restore credibility, according to him, it should be sufficient for the government to restore its primary surplus, in other words, collect more in taxes than it spends, before interest payments. Some help no doubt could come if the European Central Bank lowered interest rates further, making it cheaper for governments to issue new and roll over old debt. But how the ECB acts depends on what inflation does in the coming months. Barnier could get additional help from the new European fiscal rules that permit a softer deficit reduction by stretching it over a longer time horizon. Barnier has promised France will reduce the budget deficit below 3 percent by 2029. To do so, any future government in Paris would need to stick to his strategy for the next five years. How realistic five-year plans are in the current environment is debatable. For now, fiscal hawks will keep a watchful eye on Paris.

That takes us to Germany. Its government has managed to engineer its own largely unnecessary difficulties. Of course, compared to most of its European peers, the country enjoys enviable fiscal health. However, its government, led by efforts of finance minister Christian Lindner, is sticking to the strictest interpretation of its own national fiscal rules, as enshrined in the constitution. Moreover, by insisting on preserving a tighter numerical straitjacket in the new European fiscal pact, Germany is now having difficulties abiding by it. Even the government in Berlin could end up asking the European Commission for some leeway—additional time—to fully comply with the rules. Then again, there is politics. How credible are promises made by a government in Berlin that many now think could disintegrate within months?

One can almost hear EU officials clearing their throats. After all, this is the first test for their new rules. It needs to succeed, or the new fiscal framework will disintegrate upon its first impact with reality. Since nobody in Brussels or in European capitals wants a repeat of the euro crisis that almost pushed the bloc over the edge more than ten years ago, the commission will need to ponder carefully how much flexibility it needs to grant member states. If it acts too strictly, it risks engineering economic pain that could fuel anti-European populist backlash. If it grants too much leeway, it could undermine the new rules. But ultimately, the new framework only works if it has greater buy-in from member states. This means it is based on the hope that national governments act responsibly without having to be slapped on their fingers by someone in Brussels.

Then there is one major factor entirely beyond the commission’s reach, politics in Washington. What happens here in the coming months could disrupt many of the equations recently made in Europe and ultimately force its political leaders to reconsider many of the fiscal plans they are currently crafting. Is the EU ready?