Advantages and disadvantages of different methods to reduce the public debt ratio

Public debt ratios in the vast majority of OECD countries have become very high. If, as is likely in the absence of monetary polic ies designed to avoid it, real long-term interest rates become higher than potential growth (due to investments linked to the energy transition, central banks’ response to the rise in inflation, and low potential growth), OECD countries may be forced to switch to a much more restrictive fiscal policy. The question will then arise as to the most effective policy to reduce public debt, which would give governments fiscal space: Accepting real long-term interest rates that are higher than potential growth , while actually using a restrictive fiscal policy to gradually reduce the public debt ratio . A decision must then be made between reducing public spending and increasing the tax burden; Conducting a highly expansionary monetary policy to keep real long-term interest rates well below the real growth rate, both by driving down nominal long-term interest rates and by stimulating growth and inflation. Such a very expansionary monetary policy was used after the Second World War, for example. The first option (restrictive fiscal policy and acceptance of higher real long-term interest rates) has the advantage of not taxing savers and keeping inflation low, but it leads to a decline in investment and either low public spending or an increase in the tax burden. The second option is to keep fiscal policies expansionary and real interest rates low, which stimulates investment; but it allows inflation to rise and taxes savers, especially low-income savers who do not benefit from the rise in asset prices caused by the fact that real interest rates are kept lower than long-term growth .