Many are now claiming that public debt is much too high and that serious austerity measures are absolutely necessary to keep them in check and even reduce them. Beyond the question on whether public debt matters at all and what consequences of this austerity regime may be, another important question is whether austerity is the right way to reduce public debt. It is not like this would be the first time economies grapple with such high and even higher debt/GDP ratios. The war effort in WWII lead most economies to be in much direr situations than today, yet they managed to get out of it without too much trouble. How did they do that?
Carmen Reinhart and Belen Sbrancia pour over the data and notice a common trend: keeping interest rates low with a little bit of inflation works miracles. The negative real interest rate keep debt servicing at a minimum, while a moderate but high than usual inflation eats little by little the principal. And inflation was not even a surprise at the time, and investors accepted low returns on government bonds. This may have to do with a somewhat limited range of investment options, both because investment markets were not as well developed as today and because investors were coaxed or openly forced to buy government bonds at reduced yields. But the situation is not that different today, as everybody is frightened by stock markets and finds refuge in public bonds, money markets and simple savings accounts. And interest rates are really low, too! Now we just need a little bit of inflation.