Optimal public debt

Optimal public debt

The worldwide economies are facing some of the highest ratios of public debt in decades. For those countries that are not at imminent risk of losing market access, current policy debates center on the appropriate pace at which to pay down public debt.

Those who believe that debt is bad for growth favor a rapid reduction in indebtedness, whereas those who stress Keynesian demand management considerations argue for a measured pace of consolidation, perhaps with a ramping up of public investment while interest rates remain at historic lows.

Somewhat lost in this debate is the possibility of simply living with (relatively) high debt, and allowing debt ratios to decline organically through output growth.

While debt may be bad for growth, it does not follow that it should be paid down as quickly as possible, even abstracting from Keynesian effects on activity and output. At the same time, higher debt may imply lower returns to public capital than prior to the crisis, implying that a scaling-back of investment plans would be appropriate.

The speed of debt reduction consistent with optimal policy is likely to be very slow, with the half-life of debt adjustment exceeding 15 years. Given this slow speed of adjustment, it might be interesting to consider appropriate institutional arrangements to implement such optimal plans as a distinct and credible strategy within a class of policies that includes more costly alternatives with a similar dynamic for public debt.

Inherited public debt represents a deadweight burden on the economy, reducing both its investment potential and its growth prospects. Although the debt may have been incurred for good reasons, the higher the inherited stock, the poorer the economy (by the present value of the distortionary costs of the taxation need to service the debt). Efficiency dictates that the higher inherited debt and corresponding taxation, the lower should be public and private investment, and the slower will be output growth.

The reducing of debt or saying in other words the maintenance of optimal public debt depends on the amount of fiscal space a government enjoys. When fiscal space is ample which can never be established through some mechanical procedure there is a case for simply living with the debt, paying it down only opportunistically when non-distortionary sources of revenue are available and letting the debt ratio decline through growth. Living with the debt in such circumstances represents the best cost-benefit trade off.

The fiscal solvency is always satisfied, and that the interest rate on public debt does not carry a risk premium. Allowing for the possibility of default and increases in the risk premium following increases in public debt might affect the optimal debt adjustment following shocks. An interesting avenue for future research is thus to consider optimal debt adjustment in the context of the recently developed literature on fiscal limits and sovereign default.

Debt should be used to smooth the taxes necessary to finance lumpy government expenditures. For public investment, this implies debt-financing of projects whose social marginal product earns at least the market interest rate, but recognizing that the additional debt incurred will need to be serviced with distortionary taxation of factors that may be complementary to public capital, thereby reducing the return to public investment.

This cumulative effect on the stock of public capital is likely to be appreciable when public debt is high, implying high level of distortionary taxation.


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