How governments shrink debt quietly

When spending cannot be cut and taxes cannot be raised, there is a third route. It has been used before, and it changes what a portfolio is for.

One equation explains most of it

Whether a country’s debt burden rises or falls over time comes down to a simple relationship between four quantities: the debt ratio itself, the average interest rate paid on it, the growth of the economy in nominal terms, and the deficit the government runs before interest.

Change in debt to GDP = (r − g) × debt to GDP + primary deficit

Here r is the average interest rate on outstanding debt and g is nominal growth. When g exceeds r, the existing debt shrinks relative to the economy on its own. The wider that gap, the larger the deficit a government can run while still keeping its debt ratio stable.

The arithmetic is unforgiving. A country with debt at 120% of GDP and a primary deficit of 2% of GDP needs nominal growth to exceed its average borrowing cost by roughly 1.7 percentage points a year just to stand still. Anything less, and the ratio keeps rising.

Four levers, and only three are easy

A government can reduce interest costs, raise nominal growth through real activity, raise nominal growth through inflation, or cut the deficit. The last requires spending cuts or tax rises, which are rarely popular. The first three can be pursued together, and their combined effect has a name in economics: financial repression. Savers receive interest below inflation, and the real value of the debt erodes year after year without any formal default.

It has been done before

After the Second World War, the United States and the United Kingdom carried very large debts. Neither repaid them in the usual sense. Interest rates were held down by policy, banks were encouraged by regulation to hold government bonds, capital movements were restricted, and inflation ran moderately above the rates paid to lenders.

Source: US Office of Management and Budget, Historical Tables; Reinhart and Sbrancia, “The Liquidation of Government Debt”, NBER Working Paper 16893 (2011).

By the early 1960s the US ratio had fallen by more than half. Growth did much of the work, but the gap between inflation and the interest paid to bondholders did the rest.

What is different today

The same mechanism is harder to run now. Capital moves freely across borders, and a large share of government debt in many developed markets is held by foreign investors who can sell. Central banks are more independent than they were in the 1940s. Debt is also shorter: when a large part of it is refinanced each year, a rise in market rates feeds through to interest costs quickly. Bond markets have shown that they price these risks, through a higher premium for lending at long maturities.

What it means for a portfolio

Periods of negative real rates have historically been difficult for assets that pay a fixed nominal amount over a long period, and for cash held passively for years. They have generally been kinder to assets with some link to inflation or the ability to raise prices: real assets, companies with pricing power, and inflation-linked bonds. How these assets actually perform depends heavily on whether growth holds up, which is never guaranteed.

For us, the conclusion is not a single trade. It is a reason to decide the allocation first, to treat cash as a deliberate position rather than a default, and to review regularly whether the real return on each part of a portfolio is still positive.

What we are watching

01 The long end of the curve. The premium investors demand to lend for ten years or more is the market’s vote on fiscal credibility.

02 Inflation expectations. Repression works only while expectations stay anchored.

03 Central bank independence. Any sign that monetary policy is being steered by fiscal needs changes the picture.

04 Demand at government bond auctions. Who is buying, and at what price, matters more than headline deficits.

Sources: US Office of Management and Budget; Reinhart and Sbrancia (2011). The 1.7 percentage point figure is an illustrative calculation, not a forecast. This article is provided for information purposes only. It does not constitute investment advice, an offer, or a recommendation to buy or sell any financial instrument or to adopt any strategy. The views expressed are those of the author and of GYRA SA at the date of publication and may change without notice. Past performance is not indicative of future results. Data sourced from third parties is believed to be reliable but has not been independently verified by GYRA SA.