On mountains of debt … and taxes

Multiple crises have caused existing mountains of government debt to grow to ever higher altitudes. Is it still even possible at all to pay them down? After all, such a feat was accomplished once before in the wake of World War II. However, the underlying conditions for a second debt miracle are much worse these days. Sounder public finances at least don’t come for free.


A one-of-a-kind debt miracle

The trend is pointed upward. Government debt in most industrialized countries has continually climbed higher over the past decade. The mountain of debt by now exceeds a year’s worth of economic output in more and more countries. The list of nations where public debt surpasses annual GDP includes the USA at 134%, France at 115%, and the UK at 105% and is growing ever longer. In the aftermath of the pandemic, it is now the costly energy crisis for governments (particularly in Europe) that gives reason to expect even more debt to pile up and is pushing the budgetary retrenchment needed in many countries into the distant future. But is it still even possible at all to melt away the mountains of debt? A look in the history books reveals that this feat has been accomplished once before.


Today: Limitless? | Soaring mountains of debt

Public debt (as a % of gross domestic product) from 2000 onward

Sources: International Monetary Fund, Kaiser Partner Privatbank


Shortly after World War II (1946), public debt in relation to annual GDP stood at 121% in the USA, 270% in the United Kingdom and 75% in Switzerland. Thirty years later, those figures were down to just 34%, 49% and 47%, respectively. Vibrant economic growth coupled with largely prudent budget management were the two main causes of this “debt miracle.” During those three intervening decades, called “Les Trente Glorieuses” by some, real per capita income doubled (in the USA) or even tripled (in western Europe). This was driven not only by the enormous pent-up demand that had accumulated after two world wars and the global economic crisis of the 1930s, but was also attributable to the liberalization of foreign trade and tremendous productivity advancements. The demobilization of armed forces had a huge savings effect on public finances, and the top marginal income tax rate, which was hoisted to above 90% in the USA and the United Kingdom during World War II (read: war tax), was kept at or near the wartime level for many years thereafter. Even in the late 1970s, the top tax rates in those countries still stood at 70% or higher until the 1980s ushered in the era of big tax cuts. Predominantly balanced budgets and correspondingly stagnant debt (constant numerator) coupled with sharply rising economic output (increasing denominator) enabled a massive lowering of the debt-to-GDP ratio. Last but not least, a third ingredient was also helpful: occasional phases of high inflation rates gave an added boost to (nominal) gross domestic product, which additionally shrunk the ratio of debt to economic output.


Back then: Countries grew their way out of debt | High post-World War II economic growth rates helped

Public debt (as a % of gross domestic product), 1900–2000

Sources: International Monetary Fund, Kaiser Partner Privatbank


How it doesn’t work (or: an object lesson at 10 Downing Street)

A reprise of this budgetary retrenchment magic is hard to imagine these days because the first adjusting dial (economic growth) can hardly be turned much, at least not without causing side effects. Aging populations, waning productivity growth and widening income inequality are contributing to a steady decline in the potential rate of growth in industrialized countries. The OECD projects an average annual real trend rate of growth of just +1.7% for the USA, +1.8% for the United Kingdom and +1.2% for the Eurozone for the current decade. Even fiscal stimulus does not make it possible to escape this force of gravity in perpetuity, as the British fiscal policy experiment this autumn strikingly demonstrated. The ill-conceived mini-budget concocted by former Prime Minister Liz Truss and her Exchequer Chancellor (a.k.a. finance minister) Kwasi Kwarteng inflicted a maxi-disaster on the UK in a flash. Team Truss intended to enact massive tax cuts in order to turn the kingdom into a low-tax country and lastingly raise its trend rate of growth to +2.5% per annum. The announcement of these unfunded tax giveaways alone was enough to hurl the British pound into the cellar and spark chaos on the bond market, where a sizable “moron risk premium” got priced into long-dated UK gilts from mid-September to mid-October. Yields spreads over comparable German government bonds widened sharply while spreads versus comparable US Treasurys turned positive for a while contrary to the norm. The disciplining effect of the financial markets then brought about an abrupt fiscal policy U-turn and ultimately the resignation of Liz Truss. Her program has since been almost completely rolled back in the meantime by new Exchequer Chancellor Jeremy Hunt.


“Moron risk premium” | Poorly conceived fiscal policy warrants a risk premium

Risk premiums on 10-year British government bonds

Sources: Bloomberg, Kaiser Partner Privatbank


The spending dial also cannot be turned down at will. Defense spending has been back on the rise again for quite some time in view of an increasingly multipolar world and looks set to continue to climb in the future given the conflict in Ukraine. Demographic developments, requisite massive investments in green energy technologies and costly adaptation to climate change also necessitate rising public spending and will likely make it harder for many governments to maintain sound public finances.


No cost-free way out

In today’s world shaped by low trend economic growth, there is a clear conflict of objectives. According to a working paper recently published by the Center for Research in Economics and Statistics (CREST),1 only two of three desirable goals can be achieved in the long run in such an environment: low inflation, full employment and/or sustainable public debt. The last of the three goals cited means budget deficits that are small enough to be credibly paid back in the future via increased tax revenue or spending cuts. A textbook example of unsustainable public finances is Japan. Although inflation and unemployment are both very low in Japan, the country’s public debt policy resembles a Ponzi scheme: year after year, the government amasses annual budget deficits of 6% to 8% and has to borrow new money to service old debts. The mountain of debt grows interminably and has swelled in the meantime to 260% of Japan’s annual GDP. But the only reason why the “Japan model” works is because the country continually produces high current-account surpluses and is a huge worldwide net creditor, entirely unlike the UK for example.

The USA and Europe have been careful thus far not to go down the Japan route. Although EU fiscal rules are being eased a bit at the moment to adapt them to the current reality, sustainable public finances remain one of the bedrock principles of European monetary union. But if a government can’t or doesn’t want to cut spending by much, then sooner or later there’s no choice left but to raise revenue. It is against this backdrop that the recent debate in Germany also has to be understood. In early November, the German Council of Economic Experts, a five-member panel known as the “sages of the economy,” advocated raising the top marginal tax rate in Germany, introducing an energy solidarity surcharge for top earners and postponing the planned easing of income tax bracket creep, albeit only temporarily, mind you, with the overarching goal of countering the socially inequitable scattergun approach of energy price caps, but definitely also with reference to Germany’s mounting debt load as a result of the EUR 200 billion “double whammy” household and industry support scheme. While Social Democrat and Green politicians rejoiced over the unaccustomed backing received from the council, which heretofore had rigorously upheld the principles of ordoliberal economics, predictable objections came from the Free Democratic Party and the business community, giving Germany’s flailing traffic-light coalition government new discussion material. Regardless of near-term developments, the hot-button issue of tax hikes is bound to reappear on the agenda in the medium term – and not just in Germany, as a parting look at the British Isles reveals. Income tax brackets in the UK look set to stay frozen for years, which in the face of massive inflation is tantamount to a drastic (stealth) tax hike.

Another possible way to handle the trilemma of low-growth economics depicted above while tackling the debt problem at the same time would be simply to live with higher inflation rates. But this “solution” as well would entail an array of risks and side effects that would particularly include a weak currency and even greater income and wealth inequality. In conclusion, it remains to be said that as so often happens, there are exceptions to the rule even with regard to mountains of debt and the macroeconomic trilemma. A case in point is Switzerland and neighboring Liechtenstein, two countries that have achieved the triad of low inflation, full employment and sound public finances thus far and combine that with a strong currency and thus remain attractive locations for labor and capital.

1Jean-Baptiste Michau (2022): “The Trilemma for Low-Interest-Rate Macroeconomics”

<h5>A Safe Haven in Europe</h5>
A Safe Haven in Europe

Today’s world convulsed by the raging conflict in Ukraine, soaring inflation, rising interest rates and ongoing COVID-19 waves poses a tremendous challenge for humanity and economic activity. Liechtenstein is confronting this challenge with no public debt burden, with political and economic stability, and with military neutrality. We, Kaiser Partner Privatbank AG, are a 100% family-owned financial institution and a trusted partner to clients the world over.

Oliver Hackel, CFA Senior Investment Strategist

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