In Defense of Public Debt by Barry Eichengreen, Asmaa El-Ganainy, Rui Esteves, and Kris James Mitchener, 320 pp, Oxford University Press (2021), £22.99

Since the Global Financial Crisis of 2008, the domain of Economics has been enriched by the blending of other disciplines like Sociology and Psychology. Economic history is also making a comeback, as its insights are increasingly being used for a nuanced understanding of the current economic developments.

History helps us to situate the current economic issues and associated ambiguities in a context. In fact, Robert Solow has pointed out that, “the proper choice of a model depends on its institutional context” (Solow 1985, p. 329). The idea of “ubiquitous path dependency” of economic variables, which means that where we go next depends not only on where we are now, but also upon where we have been, has gained traction through the works of economists like Douglass North and Paul David.

Against this backdrop, the book under review titled “In Defense of Public Debt” offers a comprehensive historical account of public debt. It narrates the episodes of the debt crisis and debt consolidation, which help us to understand the context in which the current ideas on debt management have evolved.

The fiscal stimulus following the Global Financial Crisis reignited the debate on sustainable level of debt, austerity, and debt consolidation. The austerity debate was polarising in nature, peppered by the Rogoff-Reinhart’s “Growth in time of Debt” paper which propounded the 90 per cent debt threshold hypothesis. This viewpoint was also shared by unconventional macroeconomic theories like the Modern Monetary Theory (MMT) that prescribed more radical views on government expenditure and debt financing.

The ongoing COVID-19 pandemic has seen an unprecedented support offered by governments across the world, resulting in almost an explosion of public debt. All these global developments of the recent past make this book a timely read, contributing richly to the spirited discussion on debt consolidation.

The book gives a chronological account of the evolution of public debt from early city states of Greece to the Global Financial Crisis and the ongoing pandemic. It traces the key role of public debt in imparting legitimacy to the state. Although public debt’s origin can be traced back to 4th century BC, it was during the 10th century to 14th century that it evolved as an instrument of state financing.

The European states, geographically divided into smaller entities, forced to fight each other, resorted to debt funding of wars. The financial innovations like giving creditors representation in the assemblies, earmarking of revenues to debt servicing, and creation of long-term debt instruments which may be traded in secondary markets happened in the Italian city states out of the necessity to fund wars.

Political consolidation during the Middle Ages resulted in city states paving the way for nation states and larger entities. The evolution of larger political entities and complex political systems led to diverse experiments involving public debt. Some countries established institutions that reduced the sovereign’s discretionary spending power and laws that could procure debt at lower costs.

Britain, especially after the Glorious Revolution of 1688, provided an example of institutional support for sustainable public debt management. Constitutional monarchy and stability helped Britain to borrow at lower costs. Constitutional monarchy implied the rule of law, which ensured that the parties adhered to contractual obligations that led to the development of secondary markets and ease of access to raise public debt. On the contrary, Spain and France failed to pursue political reforms, which limited the sovereign’s ability to borrow. The lack of reforms, thus, increased their borrowing costs.

As nation states crystallised, public debt was used to finance the growing needs of the states. Public debt also gave legitimacy to the state, and enabled it to meet the public needs, including sewage system, water and transport systems, and other public infrastructure involving high upfront costs and social returns spread over a longer horizon.

The 18th and 19th centuries were the age of Industrial Revolution, colonialism and increasing foreign trade. The book elaborates on three episodes of successful debt consolidation during the 19th century, primarily through budget surpluses and economic growth: Britain after the French and Napoleonic Wars, the United States after the Civil War, and France after the Franco-Prussian War. This was possible as Industrial Revolution led to productivity gains along with rising colonial power and a prudent state, reducing the demands on state’s exchequer.

The dawn of the 20th century led to the birth of the welfare state. This further led to the burgeoning of public debt along with the First World War. The book elaborates in detail the consolidation of debts during the inter-War years and the different approaches to debt consolidation.

Debt reduction was achieved, in roughly equal measure, by running primary budget surpluses and maintaining a favorable differential between growth rate and interest rates. The 1920s showed how high debt can be reduced. Britain and France reduced debt by maintaining consistent primary surpluses. In Italy, forced conversion of short-term debt to long term debt by Mussolini led to reduced interest rates which had a positive impact on the differential between growth rate and interest rates. In Germany, hyperinflation liquidated the debt. Welfare expenditure and war reparations were financed by the monetisation of debt.

Central bank’s influence on public debt management became more prominent during the Second World War and the following three decades during which central banks administered rate ceilings on Treasury Bills along with huge bond purchases. The Bank of England, by the end of the War, had an extraordinary 98 per cent of its assets in the form of government securities.

The main factor helping debt consolidation during this period was the interest-growth differential. Low interest rates due to financial repression, low real interests due to inflation and high growth due to post-War reconstruction had a positive impact on public debt. Primary balances also contributed in a minor way. High growth generated enough revenues to support the social security payments.

Before the Global Financial Crisis, several emerging market economies, including Mexico, Brazil, Argentina, South Korea, Thailand and Turkey experienced serious debt-servicing problems. The book draws certain lessons from emerging market debt servicing problems during the 1980s and 1990s. First, funding fiscal deficits with short-term debt is risky because the demand for debt securities can dry up abruptly. Second, foreign-currency debt may be risky, since the sovereign’s debt-servicing capacity will depend on its ability to generate foreign exchange receipts, which can fluctuate for reasons beyond its control. Thirdly, governments should foster local markets in long-term debt securities. Finally, fiscal dominance can jeopardise banking sector stability. To illustrate, when the bond market is underdeveloped and borrowing is costly, policy makers may direct bank investments into government bonds. Thus, a fall in the prices of those bonds can affect treasury earnings, and thereby banking sector stability. The lesson, therefore, is to avoid this temptation.

The authors also underline the need for central banks to create backstops for the debt market. With volatility in the macroeconomic and financial environment, the debt-to-GDP ratio or the economic growth–interest rate differential can move in an unfavorable direction. It can also be triggered by a simple loss of confidence, as happened in France in the 1920s and Asia in the 1990s. The rollover of debt may become difficult in such situations, leading to panic among investors. In such situations, the central bank has to act as the liquidity provider and bond buyer of last resort. Towards this, the authors cite the 2012 pledge by Mario Draghi to “do whatever it takes” to prevent debt runs in the Euro Zone as a case in point. The mere expression of intention and announcement of the ECB’s readiness to backstop the markets was enough to stabilise prices.

Finally, the authors discuss the tsunami of public debts issued after the COVID-19 pandemic, pointing that countries with fiscal space could give higher support than countries with limited space. The pandemic brought to fore the need to build up fiscal space during good times through prudent debt consolidation to realise the full potential of public debt. It once again underlined the role of central banks as liquidity providers of the last resort.

While the book acknowledges the dangers of misuse and excessive dependence on public debt, it does not delve into details. The book is commendable for its craft in blending history with the contemporary insights on public debt. However, detailed narration of events where public debt failures led to problems like increased debt servicing costs, higher interests along with runaway inflation would have added completeness to the discussions in the book.

The book is largely written from a developed countries’ perspective except for a chapter on emerging markets’ crisis of the 1990s. For example, colonialism which led the globalisation of financial capital in the 19th century has had a positive impact on public debt consolidation and growth in the developed countries. But the counter factual impact on the colonies was equally important for emerging economies’ public debt experience in the later half of the 20th century. While the earlier half has been discussed in detail, the later half has been barely mentioned.

Overall, the book tries to counter the morality-based vilification of public debt by highlighting the positive ends at which public debt has been historically placed. The broad history of public debt shows that it has been the only anchor for the state during times of wars, pandemics and unexpected shocks. The historical episodes reviewed suggest that the heavy debts with which governments and societies emerge from events like wars, financial crises, and other emergencies are best stabilised through a combination of approaches: by running primary surpluses, tolerating moderate inflation, and encouraging economic growth. Shortcuts to consolidate debt like through higher inflation and fiscal dominance are unsustainable. This may be an important policy implication for a post-COVID public debt management in both developed and developing economies. Philosophically, the book appears to espouse Aristotle’s virtue theory (in Nicomachean Ethics) for public debt and debt management - “Virtue is the golden mean between two vices, the one of excess and the other of deficiency.”

Akash Kovuri^*

^* Akash Kovuri is Manager in Department of Economic and Policy Research at the Reserve Bank of India, Mumbai.