When Should Public Debt Be Reduced?

by Jonathan D. Ostry, Atish R. Ghosh and Raphael Espinoza

Executive Summary

Financial bailouts, stimulus spending, and lower revenues during the Great Recession have resulted in some of the highest public debt ratios seen 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, 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.

This paper considers optimal public debt and investment policy in the aftermath of the global financial crisis. It abstracts from rollover risks faced by countries that are near their debt limits, and also from shorter-run cyclical considerations. It is not that these considerations are unimportant— for they surely are at present in a number of countries. But they are not the dominant factors for countries that are near full employment and enjoy considerable fiscal space (even in some cases despite relatively high levels of public debt, as argued in our earlier IMF Staff Position Note on this topic, Ostry and others [2010]), a set of countries that are also in need of policy advice.

Under these conditions, economic theory provides three insights. First, inherited public debt, though accumulated for good reasons, represents a deadweight burden on the economy, dimming both its investment and growth prospects; a corollary is that an economy that has inherited a lot of public debt (for example, because of a financial crisis) will rationally choose to invest less in public capital than one with a lower level of debt. Second, if fiscal space remains ample, policies to deliberately pay down debt are normatively undesirable. The reason is that for such countries, the distortive cost of policies to deliberately pay down the debt is likely to exceed the crisis-insurance benefit from lower debt. In such cases, debt-to-GDP ratios should be reduced organically through growth, or opportunistically when less distortionary sources of revenue are available. Third, public debt should be issued to smooth the taxes necessary to finance lumpy expenditures. This action yields a version of the golden rule whereby public investment is debt-financed and undertaken to the point that social returns equal the market interest rate, with the twist that the social return will itself be reduced by the need to raise distortive taxation on labor and capital to service the higher debt.

What constitutes a safe level of debt (or ample fiscal space, as defined in Ostry and others [2010]) is, needless to say, very difficult to pin down precisely in practice, and can never be established through some mechanical rule or threshold. Stress testing public-sector balance sheets is essential to form judgments at the country level of what constitutes a safe public debt level. It may be helpful to think of debt levels as falling into three zones: a green zone, in which fiscal space is ample; a yellow zone, in which space is positive but sovereign risks are salient; and a red zone, in which fiscal space has run out. This paper is concerned with green-zone cases. Reducing debt in such cases is likely to be normatively undesirable as the costs involved will be larger than the resulting benefits.

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