The Evolution of Public Debt in a Changing Economic Landscape

Introduction: The Rise of Public Debt

In high-income countries in the past years, public debt has been surging like never before mainly due to the changes in monetary conditions and the crises that were a part of global economic cycles. To understand this better, one must look at the melding of the dynamics of inflation expectations, monetary policy, and radical economic changes. Notably:

Post-Subprime Crisis: Low Inflation and Monetary Policy Limitations
After the 2008 financial crisis, inflation stayed very low in OECD countries, averaging just 1% annually in the eurozone between 2008 and 2020—far below the 2% central banks aimed for. In response, central banks tried bold strategies, like:

• Near-zero or negative interest rates to encourage borrowing and spending.
• Quantitative Easing (QE): Central banks bought government bonds with newly created money to boost the economy.

Despite these interventions, inflation failed to recover. The newly created money did not flow into consumption or investment but instead fueled asset price inflation, leading to significant increases in the valuations of financial assets, real estate, and bonds. Long-term interest rates, especially in the eurozone’s core countries, fell sharply, with some even turning negative.

Due to very low interest rates, there has been a period where all the traditional challenges to public debt sustainability have just vanished. With interest rates falling below the growth rate of the economy, the finances of governments were such that it was easy to accumulate debt in a trivial or virtually cost-free manner in some cases at negative real rates.

The Energy Crisis and Structural Shifts Post-COVID-19
With the global economy now rebounding, one of the areas that is being impacted is global trade. Among the most affected of the sector concerns is supply-chain supply, with micro and macro related demand advantageous as a supply overwhelmed with goods such as electronics and households. This overwhelmed the supply chain with raw materials, semiconductors, and even freight transportation services. This caused inflation to rise sharply, made worse by the Russia-Ukraine war, which created additional disruptions:

• Energy shocks: Russia cutting off natural gas supplies to Europe caused energy prices to spike, especially for electricity, natural gas, and coal.
• Renewable energy costs: Moving toward renewable energy, while necessary, comes with high costs, such as dealing with inconsistent supply, further driving up energy prices.

Inflation has also been made worse by changes in labor markets, such as workers gaining more bargaining power and industries reshoring production to improve economic security. They have also raised energy costs by locking in price-setting factors, especially in Europe, making a transition to energy independence, and gearing investments toward renewables particularly daunting.---

Rising Interest Rates and Fiscal Constraints
The eurozone is facing big challenges now that the days of low interest rates and mild inflation are over. Governments are feeling the pressure to spend more in order to:

• Help households keep up with rising costs.
• Pay for energy transitions.
• Stay competitive despite higher expenses.
• Invest more in schools, healthcare, and infrastructure.

But with real interest rates going up, governments have to deal with old problems again, like making sure they don’t have too much debt. For example, in France, low interest rates used to make it okay to run a primary deficit of around 3% of GDP. Now that interest rates are higher, France would have to cut that deficit completely, which means reducing it by 3% of GDP. This creates a tough situation for balancing the budget.

Addressing the Deficit Challenge: Policy Options
Reducing the public shortfalls and meeting increasing expenditure needs are hard work. Certainly, some suggestions:

Increase of Retirement Age: This can be the case in France where people retire early in comparison with other countries. Having more older people would contribute to their staying in the labor force and reduce the budgetary problems by the continued generation of output. For instance, if employment rates for those aged 60–64 in France were as high as in Germany (74%) or Sweden (77%), it could reduce France’s deficit by 1% of GDP. But this wouldn’t be enough to solve the whole deficit issue.

Central Bank Help: In theory, central banks could keep interest rates below inflation to help fund government spending by creating an “inflationary tax.” But with inflation and interest rates going up, this idea doesn’t seem very realistic anymore.

Tax Hike: Increased tax rates may be the best measure to bridge gaps. Even though it isn't exactly nice to most, more stringent tax measures become favorable to spending on energy transition, boosting industries, and promotion of measures that are beneficial to society.

Conclusion: A Complex Fiscal Landscape

The change from a time of low interest rates and easier-to-handle deficits to one with rising inflation and stricter budget limits is a big deal for advanced economies. Governments now have to figure out how to keep their budgets sustainable while also dealing with important issues like energy needs, funding social programs, and staying economically competitive. Trying to balance these things will probably mean making tough and not-so-popular choices, like raising taxes, which could upset people but might be needed to keep things stable and move society forward in these uncertain times.