Where Could Global Affairs Head as Public Debt Continues to Rise?

Unbearable burdens on future generations with the possibility of financial crises and political instability

Has public debt in the developed world become fundamentally unmanageable? Recent figures on these debts clearly show how far we have moved away from the old model of public finance, where debt accumulated during wars and was repaid in peacetime.

Take the United States as an example: while the debt-to-GDP ratio in the world's largest economy fell from 106% in 1946 to 21.6% during 1990-1991, it has since risen again to nearly 100%, due in part to the financial crisis and the COVID-19 pandemic.

The worrying fact is that in the United States, as elsewhere, economic growth has slowed compared to the decades following World War II, interest rates have risen, and the budget deficit gap has widened. The Congressional Budget Office currently projects the debt-to-GDP ratio to reach an unsustainable 156% by 2055, which could weaken the role of U.S. Treasury bonds as a cornerstone of the global financial system.

Meanwhile, the International Monetary Fund expects the average public debt of European countries to double over the next fifteen years if policies remain unchanged, leading to higher borrowing costs, lower growth, and financial instability—all of which impose an unbearable burden on future generations.

Of course, there are proven methods to reduce the debt-to-GDP ratio. Achieving a primary budget surplus before interest payments is a key policy tool, and economic growth, which boosts tax revenues and reduces cyclical spending, clearly helps address the issue. Keeping real interest rates below the growth rate is a highly effective mechanism for reducing debt. Informal default through inflation plays a critical role, as does financial repression, where governments force investors to buy debt securities at below-market rates.

The post-war experience of the United Kingdom offers a case study of how these factors interact. The debt-to-GDP ratio fell from over 250% in 1946 to just 42% after three decades. In pioneering research, Barry Eichengreen and Roy Stevens show that during most of the debt consolidation period (1946-1955), the UK ran large and sustained primary budget surpluses despite the massive expansion of the Labour government's welfare state.

However, inflation was the largest contributor to debt reduction, accounting for more than 80% of the consolidation during that period. Since 1955, fiscal discipline and economic growth have played the biggest roles in reducing debt—a surprising fact given Britain's economic inefficiency record at the time—because the contribution of consumer price inflation, which peaked at 24% in 1975, was offset by the skyrocketing interest rates.

The policies behind this massive debt reduction have been described as a struggle over income distribution, revolving around whether to drain rentiers, exploit workers, or burden entrepreneurs with heavy taxes. In reality, these groups overlap, especially since today's rentiers include millions of pension fund participants.

This struggle today is marked by increasing pressures to provide generous support to address aging populations and the resulting high costs of pensions, healthcare, and more. Add to that the costs of geopolitical tensions and climate change.

Could the massive growth stimulus from artificial intelligence save the situation? In a recent research paper from the Deutsche Bank Research Institute, Matthew Luzzetti and colleagues relied on average estimates from a group of leading economists for this stimulus, suggesting that AI could raise productivity by between 0.5% and 0.7% annually. However, they concluded that the growth impetus is more likely to slow the rise in debt rather than sharply reverse its trajectory. So, there is no sudden solution here.

In a world where growth increasingly depends on debt, political polarization and populism generate conflicting demands for increased spending and tax cuts. Meanwhile, central banks have complicated matters by tending to provide safety nets for collapsing markets while failing to curb excessive optimism. Their inflation targeting now makes it harder to reduce debt through inflation. Inflation must be unexpected so that rising interest rates do not offset its effect. Thus, this solution would, in fact, depend on central banks financing public debt by political decision.

Financial repression is also problematic in a more complex financial world, where the exchange controls needed to support such repression are likely to be breached. Accordingly, strict discipline in the bond market, not political will, is the key to debt consolidation, which ultimately threatens financial crises and political instability. For this reason, Swedish economist Anders Åslund sees the current situation as reminiscent of 1929. Even if you consider his view extreme, it is hard to disagree that these conditions cannot end well.