By Jonathan D. Ostry
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 forty years. Recent debates have centered on the pace at which to pay down this debt, with few questions being asked about whether the debt needs to be paid down in the first place.
A radical solution for high debt is to do nothing at all—just live with it. Indeed, from a welfare economics perspective—abstracting from real world problems such as rollover risk—this would be optimal. We explore this issue in our recent work. While there are some countries where clearly debt needs to be brought down, there are others that are in a more comfortable position to fund themselves at exceptionally low interest rates, and that could indeed simply live with their debt (allowing their debt ratio to decline through growth or windfall revenues).
The case for living with debt
A simple way to understand the basic intuition for just living with debt is to recall Robert Barro’s “tax-smoothing” principle (whereby constant tax rates are efficient because distortionary costs are typically convex—rising at a faster rate—in the tax rate). The economic burden of public debt is the distortionary cost associated with the taxes needed to service it, potentially in perpetuity. But that is a sunk cost, already incurred, and— short of default—now unavoidable. It provides no reason to further distort the economy by temporarily raising taxes only to lower them again once the debt has been paid down.
Three objections may be raised to this argument: (i) in some countries, debt is dangerously high and there is risk of a funding crisis; (ii) debt is bad for growth and should therefore be paid down; (iii) there may be large fiscal shocks in the future, so it is sensible to build up buffers against them.
Each of these is a potentially serious objection and merits careful consideration.
Avoiding funding crises
It is clear that in some cases, debt indeed needs to be paid down. Some countries have little fiscal space (they are close to a debt limit at which markets may demand a huge risk premium or even deny them access) and debt sustainability constraints in such situations will leave them little choice but to deliberately run budgetary surpluses. But what is necessary for some countries is not what is appropriate for all. Policy advice always needs to be tailored to country circumstances—there should not be a one-size-fits-all approach to debt repayment issues any more than in other spheres of economic policy making.
It may be helpful to think of countries’ debt levels falling into three zones: a green zone where fiscal space is ample; a yellow zone where space is positive but sovereign risks are salient; and a red zone where fiscal space has run out. In the red zone, and possibly the yellow zone, debt sustainability constraints leave few options, and countries indeed need to focus on bringing the debt down. This certainly applies to countries like Greece. But in the green zone, where the sovereign is in the comfortable position of being able to fund itself at reasonable—or even exceptionally low—interest rates, and there is no real possibility of a debt-induced sovereign crisis, living with debt, and allowing the debt ratio to decline organically through growth, may be a better option than deliberately paying it down.
Ultimately, this comes down to a cost-benefit analysis. The benefit from repayment is small for countries with ample fiscal space because, while sovereign debt crises are costly when they occur, their occurrence is rare, even at elevated debt levels, and more importantly the probability curve is very flat in the debt level, so that crisis risk hardly falls when debt is reduced from, say, 120 to 100 percent of GDP. The cost of reducing debt can be much larger, however, even if adjustment is spread out over several years (the cost rises steeply if the pace of adjustment is faster), because distortive taxes or cuts in productive spending (needed to run a budgetary surplus) have a deleterious permanent effect on the capital stock, output, and consumption.
Debt is bad for growth
A second argument for paying down the debt is that debt is bad for growth. That is indeed true: the distortionary taxation required for servicing public debt reduces the incentives of both capital and labor, resulting in lower private and public capital stocks, and lower growth. But it does not follow that paying down the debt is good for growth. This is a case where the cure may be worse than the disease: paying down the debt would require further distorting the economy, with a corresponding toll on investment and growth.
Saving for a rainy day
The third counter argument to just living with the debt is to build additional margins to cope with unanticipated events. The option value of lower debt would be particularly high in the face of catastrophic events (for example, a financial crisis in which a public backstop is essential), in which the government needs to ramp up borrowing massively. If debt is high when such a shock occurs, a heavy penalty may be exacted as sovereign risk premia rise and, in extreme cases, a shutout from the markets would ensue. Put simply, debt needs to be reduced today to save for a rainy day tomorrow. This argument has considerable merit—even for countries in the “green zone”—but again it is a matter of balance. Lower debt provides larger margins for unexpected contingencies, but if it comes at the cost of investment and output growth, the margin may be somewhat illusory. That is why we argue in our paper that, while the nominal value of the debt should not be paid down, the debt ratio should be allowed to decline organically.
No mechanical exercise
Advanced economies are contending with some of the highest debt ratios seen since the Second World War. But not all are in the same boat: for some, whose sustainability is more precarious, reducing debt is the imperative. Others are in a more ambiguous situation where there is no immediate risk of funding problems but nor is there any room for complacency. And a few appear to be in the “green zone” with ample fiscal space. Of course, deciding which zone a country is in is not a mechanical exercise but will require judgments based on stress testing fiscal balance sheets to withstand extreme shocks. But the mantra that it is always desirable to reduce public debt must not go unquestioned. A comparison of costs and benefits must underpin policy advice. For countries in the green zone, the case for living with the debt is a strong one.