Two trade-offs on public debt

I continue to receive welcome signs of appreciation for the speech I gave yesterday in Rapallo and which you can find in the previous post. Someone also asked for the slides to be published and I will certainly do so, but first I would like to quickly highlight here two things that are not in the slides, but that I said and on which I think it is important to focus attention.

A false trade-off

The first thing I would like you to think about is an obvious limitation of standard economic theory, according to which public investments are somehow alternative to private investments, in the sense that, to use the language of economists, they would “crowd out” them (the English term used is: crowding out ). This vision derives from the very stylized idea according to which the only determinant of the volume of investments is the interest rate. If things were like this, then it would make sense to think that if the State makes investments by financing them in deficit, that is with public debt issues, and assuming that these issues raise the interest rate, then public investment would determine a contraction of private investment through the interest rate channel. In reality, as I tried to explain yesterday (but not only yesterday), among the overall determinants of the profitability of an investment there are also the overall conditions of aggregate demand and the state of infrastructure. Nobody invests to bring to the market with a road that doesn't exist a good that nobody demands. Would you (with the exception of Corrado) do it? Not me, but I am not a good example: the problem is that no one does it. We should therefore talk about crowding in (not out ) of private investment by public investment. If we did, we would also understand why in a period in which interest rates were kept very low, private investment did not actually explode. The reason is simple: because at the same time public investment was cut, deteriorating the state of overall aggregate demand and letting infrastructure go to ruin. The correct economic theory is the one that best fits the data: what I have told you explains why it can happen that there is water, but the horse does not drink.

A real trade-off

Another thing that I would not want to go unnoticed in the folds of the speech refers to an actual difficulty to which a high level of public debt can expose. This still escapes many, but it is important that we, who prefer to anticipate events (humbly aware of the fact that we are not able to influence them that much anyway), put our heads down. High levels of public debt determine a trade-off between macroeconomic stability (intended as control of inflation) and financial stability. The reason is very simple: given that inflation depends on the law of supply and demand, and that, consequently, the only tool a central bank has to control it is to reduce demand by raising interest rates, when debt positions are very high there is the risk that an increase in interest rates motivated by the desire to combat inflation makes it too expensive to refinance existing debt positions. To put it another way, and thinking about public debt, when Paul Volcker started his policy of high interest rates to fight inflation in the early 1980s, the average level of public debt in advanced countries was around 40%, and the increase in real rates of about four to six points started a spiral in many countries where people borrowed to pay the interest on the debt. Now the average debt is more than double, that is, over 80%, and therefore even more modest increases in interest rates could lead us into a similar spiral, which could send public debt exposures, but especially private debt exposures, out of control. For this reason, it would be important for these to be diluted in some way, pushing nominal growth, that is, real growth and inflation.

Here: these two things were not in the slides, but they were perhaps the two most important things I had to say yesterday. I hope they have opened up some useful perspectives for you.

This is a machine translation of a post (in Italian) written by Alberto Bagnai and published on Goofynomics at the URL https://goofynomics.blogspot.com/2025/06/due-trade-off-sul-debito-pubblico.html on Sun, 08 Jun 2025 11:43:00 +0000. Some rights reserved under CC BY-NC-ND 3.0 license.