by Jonathan D Ostry, Atish R Ghosh and Raphael Espinoza
Appeared originally at Voxeu.org 22 June 2015
High public debt ratios dominate today’s fiscal policy discussions. This column argues that paying down the debt involves a trade-off that balances the gains from the insurance value of low debt against the costs of an insurance premium – higher distortionary taxation. When countries have fiscal space and no real prospect of a sovereign crisis, the cost of bringing down the debt is likely to exceed the crisis-insurance benefit. The best policy might be to simply live with higher debt.
What goes up must come down, or so the saying goes. But how can debt be brought down through deliberate policy action? In the fiscal sphere, a popular mantra is that – to the degree that public debt has surged following the Global Crisis – debt needs to be brought down to more prudent levels (Marcet et al. 2002).
High debt is risky and can, in the blink of an eye, lead markets to charge sky-high lending rates or even shut a sovereign state out of the market altogether (Ostry et al. 2010).
High debt is bad for growth
High debt is also bad for growth. This is somewhat controversial since causality can run both ways (see Reinhart and Rogoff 2010). But if servicing the debt requires higher taxes, then a hit to growth is certainly not far-fetched. High debt leaves little margin for unexpected disasters (or financial crises). Getting wet on a rainy day is rarely pleasant – better to invest in an umbrella when the sun is out if there’s the chance of rain later. Fiscal prevention is easily worth a pound of fiscal austerity during a crisis.
Taking out insurance is a good idea for all sorts of types of risks but insurance has a cost. People will generally compare benefits and costs before deciding to buy or not, so is deliberately running a budgetary surplus to pay down public debt always a sensible policy? As a matter of economic logic the answer is obviously ‘no’. The net benefit of insurance need not be positive for all countries at all times. Just as we don’t buy insurance for everything, we should also avoid a knee-jerk reaction to pay down the debt as insurance against future risks.
Not just an ‘academic’ issue
This is not a mere ‘academic’ issue. Financial bailouts, stimulus spending, and lower revenue during the Great Recession have resulted in some of the highest public debt ratios in advanced economies in the past 40 years. Recent debates have centered on the pace at which to pay down this debt, with few questions being asked about the desirable level of public debt to which the economy should converge following a debt shock. While some countries face debt sustainability constraints that leave them little choice (e.g. Greece), others are in the more comfortable position of being able to fund themselves at reasonable –even exceptionally low – interest rates. For these countries, there is a very real question of whether to live with high debt while allowing the debt ratio to decline organically through growth, or to pay it down deliberately to reduce the burden of the debt. It is this issue that we analyse in our recent paper (Ostry et al. 2015).
Pay down or don’t pay down the debt?
To analyse the normative aspects of public debt, it is useful to abstract from inter- and intra-generational distribution issues as well as the international transfer problem, and focus on a situation where the debt is one that we owe ourselves. To yield policy insights, the framework must incorporate two features:
- At least part of government spending should be on productive capital; and
- Only distortionary taxes should be available to finance spending.
In such a setup, public borrowing does not relax the economy’s resource flow constraint, and public spending necessarily crowds out private spending. The only purpose of public debt is to shift the burden of taxation over time so as to reduce its total distortive cost.
In such a world, what happens if there is an exogenous increase in public debt (the increase is exogenous in the sense that it does not correspond to higher public investment or provision of the public good, but rather results from some extraneous event such as fallout from a financial crisis).
Conceptually, there are three possibilities:
- Optimal policy could involve paying down debt immediately so that, following the initial period, the debt path returns to the baseline scenario; or
- The policy could involve paying down the debt more gradually so there is gradual convergence to the baseline scenario; or
- The economy could simply live with the debt forever.
A priori, it is far from clear which will obtain the best result. On the one hand, paying down the debt quickly involves high rates of taxation and correspondingly large distortionary costs; on the other hand, never paying it down means servicing it forever, thus incurring the distortionary cost of taxation in perpetuity.
The key to solving the puzzle is to recall that in a setup such as this, despite private and social valuations being different, the government’s discount rate will equal the market interest rate. Suppose that, in any period, the government is considering paying down one euro of public debt. If it does so today, it incurs the distortionary cost of raising another euro of revenue. If it defers repayment until tomorrow, the debt will have grown by the market interest rate and the cost will be the distortion associated with raising an additional euro. But the government discounts the future at precisely the market interest rate so it gains nothing by paying down a euro of debt today. Since the same argument can be applied to any period, the government will just live with the original inherited debt. In fact, applying Robert Barro’s (1979) tax-smoothing argument, it can be shown that taxes will be set so as to achieve a constant distortionary cost. Once the steady state is achieved, this will imply constant tax rates and revenues, the latter equal to the interest payments on the debt. If taxes were set any higher, debt would decline. So, eventually taxes would decline, violating the tax-smoothing principle. If set any lower, debt would grow explosively, eventually requiring higher taxes which, again, would violate the tax-smoothing principle.
Let us return to the insurance benefits from repaying public debt. Take a country that, while it may have quite a bit of debt, faces very low borrowing costs and for which there is very little real danger of a sovereign crisis. The benefit of insurance for such a country is likely to be small. In the cross-country evidence, fiscal crises are rare events and, more important, the crisis probability curve is very flat in the level of public debt. A fiscal effort today will reduce the probability of a crisis a little, but the payoff is likely to be very small. In our recent paper (Ostry et al. 2015) we quantify the crisis-insurance benefit of reducing debt in such circumstances. Of course, the risk-reducing benefits of lowering debt are going to be large for countries that may be in a ‘yellow’ or ‘red’ zone in terms of available fiscal space, for which sovereign risks are salient, or, perhaps, fiscal space has run out altogether. For such countries, the payoff to reducing debt could be very high indeed.
The discussion so far has focused on the crisis-insurance benefit of repaying debt. But what is the cost of this insurance? When a country runs a budget surplus to pay down its debt, there is no free lunch. The money has to come from somewhere – either higher taxes (which undercuts the productivity of labour and capital) or lower spending (which, unless spending is completely wasteful, has a similar effect). Sometimes the debate seems to assume that the insurance acquired through lower debt is free. Advocates ‘fixing the debt problem’ stress the crisis insurance benefit of lower debt, without mentioning the upfront cost of the insurance.
Our paper shows that insurance can be expensive in terms of the higher taxation needed to run a budget surplus. And more importantly for countries that have ample fiscal space, the cost of insurance is likely to be much larger than the benefit. It is much better in these circumstances to simply live with the debt, allowing the debt ratio to be reduced organically through higher growth.1 Economic welfare in fact is likely to be significantly higher, our paper shows, when a country chooses to live with the debt (allowing the debt ratio to decline organically through growth, or as a result of exogenous revenue booms) than if it chooses to pay down the debt or even build up assets in anticipation of a rainy day, as some have recommended (Marcet et al. 2002).
There is one further aspect of the issue that bears highlighting. It is often said that debt must be paid down to lay a firmer foundation for economic growth. This is, as a general policy prescription, a fallacy. Debt is indeed bad for growth. But the growth cost of high debt is a sunk cost. And that cost is only amplified if countries take steps to raise taxes today to pay down the debt, only to lower them again tomorrow once the debt is down.
When and only if countries have ample fiscal space, there is no need to obsess about paying down the debt. Living with the debt is likely to be the better policy.
- Barro, R (1979), “On the Determination of the Public Debt”, Journal of Political Economy 87 (5): 940-71.
- Marcet, A, T J Sargent and J Seppala (2002), “Optimal Taxation without State-Contingent Debt”, University of Illinois Working Paper 01-0127.
- Ostry, J D, A R Ghosh, J I Kim and M S Qureshi (2010), “Fiscal Space”, IMF Staff Discussion Note 10/11.
- Ostry, J D, A R Ghosh, and R Espinoza (2015), “When Should Public Debt Be Repaid?”, IMF Staff Discussion Note 15/10.
- Reinhart, C and K Rogoff (2010), “Growth in a Time of Debt”, NBER Working Paper 15639.