Is debt cancellation the right thing to do?

Just a few years ago, the idea sent shivers through the market. Raising the debt ceiling prescribed by the Stability and Growth Pact, a set of rules governing the euro zone, from 60% to 100% of GDP would trigger a new round of questions about the solvency of highly indebted countries like Greece and Italy. And yet, it came from the most unlikely source: the European Stability Mechanism, an institution tasked with supporting eurozone members in financial difficulty.

Faced with a pandemic that has pushed debt levels to unprecedented levels, the euro zone has launched a consultation process to revise rules hitherto seen as sacrosanct, especially among fiscally frugal northern members. However, the idea of ​​an overhaul of the debt ceiling still faces a daunting task to embrace. “It’s a politically ‘welfare’ measure, but it wouldn’t change the existing level of debt or the fact that interest rates need to stay low for it to be sustainable,” said Rui Soares, investment analyst at FAM Frankfurt Asset Management. .

The European debt conundrum
Eurozone fiscal rules were suspended during the pandemic to give governments some leeway to deal with the impact of the lockdowns, but they will come back into force in 2023. However, the crisis has put ideas on the table even further. more radical. In November 2020, Riccardo Fraccaro, an aide to then Italian Prime Minister Giuseppe Conte, suggested that the European Central Bank (ECB) cancel the government bonds it bought during the pandemic, thus canceling a large part of the sovereign debt. The idea was picked up by a group of prominent economists and politicians who argued in an article published by EURACTIV that canceling sovereign debt held by the ECB would provide fiscal space for a quick and green recovery. “The post-Covid era must not be a return to what was ‘normal’ before the crisis, but a profound transformation that current stimulus programs do not guarantee,” said Jézabel Couppey-Soubeyran, economist at the Panthéon-Sorbonne University and one of the signatories of the article, told World Finance.

Proponents of debt cancellation point to the massive bailouts of private banks during the global financial crisis of the early 2010s as a precedent justifying sovereign debt cancellation of a similar magnitude. However, it is another crisis that still haunts European policy makers. Those who still remember the long saga of Greece’s near-default in 2015 fear that opening such a politically charged debate could distract from Europe’s deeper problems. When ECB President Christine Lagarde was asked about the prospect of debt forgiveness, she outright dismissed it as a breach of EU treaties: “I don’t even wonder It’s as simple as that,” she said. Many analysts also note that investors are becoming more worried about historically high levels of private debt, with heavily indebted “zombie corporations” becoming increasingly vulnerable after pandemic relief programs end. “The problem is not public debt, but high levels of private debt,” Soares said. “Even if you restructure public debt, you cannot normalize monetary policy. If interest rates were to rise significantly, many private borrowers would collapse.

One of the reasons why debt cancellation remains controversial is the risk of moral hazard. European budget hawks fear that this will encourage indebted countries like Italy, whose public debt exceeded 154% of its GDP in 2021, to continue borrowing without implementing the necessary reforms. “You have a certain pressure for the system to reform, which is better to do without debt restructuring. You see it in Greece, Spain and Portugal, whose economies are structurally on a better footing compared to 2010,” Soares said.

Even if you restructure public debt, you cannot normalize monetary policy. If interest rates were to rise significantly, many private borrowers would collapse

At the center of the debate is central banks’ key tool to deal with rising debt: quantitative easing (QE). During the pandemic, the ECB launched a €1.85 billion bond-buying program which is due to expire in March. Critics argue that QE is a form of indirect financial aid to states that creates social tensions because it benefits wealthy asset holders and causes asset price bubbles. Debt cancellation would help governments increase public investment and allow central banks to safely reduce QE, according to Couppey-Soubeyran. Skeptics counter that extreme times demand extreme measures. “The solution is infinite quantitative easing – keeping interest rates low forever,” Soares said, adding, “What is ‘back to normal’? Why couldn’t the ECB maintain quantitative easing indefinitely?Japan has been practicing quantitative easing for more than 25 years and is not returning to the so-called normal.

Another line of criticism of debt cancellation relates to its practicality. In an article published last March, several eminent French economists argued that the cancellation of sovereign debt would be a form of accounting gimmick that would change little, since it would cancel sovereign bonds already held by national central banks. Governments, they argued, should instead gain fiscal space by taxing wealthy citizens and multinational corporations. “If you were one of the richest people in Europe, you would be happy to see that policymakers want to cancel the debt rather than tax you,” said Anne-Laure Delatte, an economist and researcher at the University. Paris-Dauphine.

The student debt crisis in the United States
In the United States, the pandemic has added a new twist to a debate that has raged for decades: what to do with the more than $1.7 billion in student loans owed by 43 million Americans. The Biden administration has approved more than $9.5 billion in student loan relief, allowing borrowers to skip payments, accrued interest and defaults for about two years, with payments set to resume in February.

However, critics say it doesn’t go far enough. During his campaign, Biden has supported the idea of ​​student loan forgiveness, but so far he has resisted calls from left-leaning Democrats to forgive student debt up to $50,000, saying that it would only support the cancellation of loans up to $10,000. Other government officials, including Education Secretary Miguel Cardona, have signaled that broader debt forgiveness is still under consideration. Blanket debt forgiveness would be counterproductive, according to Sandy Baum, a senior fellow at the Washington, DC-based Center on Education Data and Policy and author of a book on student debt: “Borrowers with Higher Education Levels have generally worked remotely during the pandemic. These are not the people who are currently struggling economically. Most borrowers can and should repay the money the federal government has given them to help finance their education expenses.

What makes student debt a political hot potato is its correlation to another issue that has dominated American politics for the past two years: race. African-American graduates owe an average of $25,000 more than their white counterparts. “The burden is borne disproportionately by borrowers of color, especially women who are paid less for the same work and who often have to leave the workforce to provide care. The Biden administration also backed away from offering free community college in its ‘Build Back Better’ program, which could potentially cut the cost of a college degree in half,” said Elizabeth Shermer, an academic at Loyola University in Chicago and author of Indentured Students: How Government-backed loans have left generations drowning in college debt.

A tool to fight against climate change
Curiously, the pandemic puts an end to the idea that the increase in public debt is a problem that must be tackled at all costs. Many hope that higher inflation will slowly eliminate it, as happened with massive debt levels after World War II. The health crisis has also revived the debate on the existence of a specific debt/GDP ratio beyond which public debt is not sustainable. Although this was assumed to hold around 120% during the European sovereign debt crisis, many economists point to the massive increases in public debt during the pandemic as proof that the pursuit of specific debt targets is a pipe dream. At the height of the pandemic last year, public debt in the euro area rose from an average of 86% to nearly 100% of GDP (see Figure 1); France’s debt is approaching the 120% threshold, while even traditionally fiscally cautious countries like the UK have almost exceeded 100%. “Financial markets are myopic and have very short-term memory,” Delatte said. “In the past, many countries have recovered quickly from credit events. There is no empirical evidence on the level of the debt-to-GDP ratio above which public debt is unsustainable.

What makes the idea of ​​debt restructuring more appealing to those who opposed it until recently is the battle against an enemy deemed more dangerous than COVID-19: climate change. Brussels-based think tank Bruegel found in a recent study that EU countries will have to sacrifice up to 1% of their annual GDP to meet EU carbon reduction targets , thereby justifying changes to EU rules that would exempt green projects from debt calculations. The bloc is also considering a plan to give developing countries bilateral debt relief as a reward for green investments, including an initiative to cancel $8.5 billion of South African debt on the condition that the country closes the most of its coal-fired power plants. “The world is not going back to normal,” Delatte said. “We will need more public spending and investment in green innovation to protect citizens from climate change. The main risk is therefore not to go into more debt, but not to spend enough.