How to get rid of public debt

With most western countries buried in public debt and looking to clean up their act it might be a good to offer an overview of their options. There is basically three ways for a country to lower its debt to GDP ratio, austerity, growth and inflation.

Most debt ridden European countries are now implementing some sort of austerity plans. These basically involves raising taxes and cutting spending. The logic here is simple, turning budget deficits in to budget surpluses they can start to pay off their debt instead of adding to it.

These practices however have the downside of strangling economic growth. Since a country's ability to pay off its debt depends on it's size relative to the size of the economy, this matters. If a country's economy would simply grow by a few percentage points every year its debt to GDP ratio would in time fall to manageable levels, given that its debts aren't growing faster then the economy itself. The easiest way to manufacture growth is by increasing spending and cutting taxes, this practice would however add to the deficit, which is the opposite of what we are trying to accomplish. But there are other ways to create growth without adding to the budget deficit. A country can deregulate product and service markets in order to raise productivity. Ease labor market laws in order for the country's workforce to be better utilized. Promote competitiveness by ending government monopolies and selling off state owned firms, both in the hope of raising productivity but also to collect some much needed cash for debt payments.

Another way is to bump up inflation. Most western countries have an inflation target around 2%, if this was raised by a few percentage points this would quickly eat away at existing public debt. The downsides of inflation has previously been discussed in this blog but much of the negative sides of inflation could be remedied if the increased inflation was kept at a stable rate, let's say 6% instead of 2%. The higher inflation rate would be known in wage negotiations so that new wage increases could take it in to account. Interests rates would adjust themselves to the expected higher inflation so to not punish savers by keeping the real interest rate (interest rates minus inflation) unchanged. Of course buyers of newly issued government bonds would take the new higher inflation rate in to account too, so it would not help the indebted country here. It would only help them with bonds issued when expected inflation rates were lower, on these the cost for the state would be significantly lowered. Imagine a 10-year bond being issued before the inflation increase, the indebted country would then only need to pay back a portion of that debt in real terms. There is however a risk that once a country has bumped up its inflation target markets might come to fear another increase and demand to be compensated for this risk by a higher interest rate.

A combination of the first two somewhat contradictory measures are already being pursued to some extent in in troubled European countries. Inflation has however been kept down by successive interest rate increases by the ECB. It probably wouldn't hurt if it took a more relaxed attitude to inflation fighting and let prices rise a bit. Especially now that German growth seems to be slowing and a low euro interest rate is less likely to create bubbles in the German economy.