When Should Public Debt Be Reduced?

Econintersect:  The headline is the question forming the title of a paper published this month by IMF (International Montary Fund) economists, Jonathan D. Ostry, Atish R. Ghosh, and Raphael Espinoza.  The “paper” is really less formal than a document prepared for a professional journal, and is labeled by the IMF as an “IMF Staff Discussion Note“.  The question discussed regards the handling of sovereign debt during and following financial crisis and specifically discusses situations resulting from the Great Financial Crisis of 2008.

The paper describes a “pure theory of public debt” which focuses on “the debt we owe ourselves“.  In this framework, which does not include inter-generational issues and international transfers, the authors assert:

To yield policy insights, the framework must incorporate two features: at least part of government spending should be on productive public capital; and only distortionary taxes should be available to finance spending. In such a setup, public borrowing does not relax the economy’s flow resource constraint, and public spending necessarily crowds out private spending. The purpose of public debt is to shift the burden of taxation over time so as to reduce its total distortive cost.

Econintersect note:  This appears to be based on a loanable funds theory of banking and therefore does not include the private sector creation of credit. It is by such mechanisms that the result empirically observed shows an increase in private sector savings with increasing sovereign debt.  In such an environment, which we submit is operative currently, crowding out of the private sector does not occur with government deficits.  Crowding out occurs with government surpluses when taxation is removing public savings.  Of course the discussion by the authors of the burden of interest payments on government debt is not affected by this incorrect assessment of crowding out:  Interest payments on government debt (we do not include the possibility of rolling interest due into deficits) require part of the tax inflows which are thereby not available for public investment.

The paper concludes that reduction of sovereign debt for countries “in the green zone” is likely to be “normatively undesirable as the costs involved will be larger than the resulting benefits” in environments where recovery from a financial crisis is in progress.

Click on title page below to read the entire paper:

John Lounsbury