It is good to see the fiscal policy debate ramping up in advance of the December budget. One aspect of the debate that has received a good deal of attention – not least from the Minister for Finance himself – is the problem of compounding debt service costs. This concern is understandable given the scary arithmetic involved. But it is not something usually emphasised by economists and I think is distorting the debate.
The reason is the standard one of discounting. To be more concrete, suppose that we are considering a debt-funded lowering of taxes this year by €1 billion to be paid for by increased taxes in five years time. Assuming a real interest rate of 5 percent, the €1 billion compounds to $1.28 over five-year period. But the present value of $1.28 billion 5 years from now is just €1 billion (using the same real interest rate to discount future cash flows). In other words, the compounding and the discounting are a wash. In five years time we may very well look back and wish we hadn’t accumulated the extra debt. But that doesn’t change the appropriateness of using the discounted cash flow when deciding on the optimal fiscal strategy today. I doubt if any economist would forget to discount the future benefits from a public capital expenditure programme; but such forgetting seems surprisingly common in the fiscal policy debate.
There is a long and distinguished debate in economics about the appropriate way to discount the future, most recently (and heatedly) in the debate on the required policy response to climate change. Nicholas Stern in particular has argued against discounting using market rates where policies have effects over many generations. But I think it is fair to say that most economists support the conventional approach using market rates, at least as it applies to shorter-term decisions.
Of course, there are a number of good arguments for front-loading deficit reduction in coming budget, many of which have been made by Philip Lane in his recent posts. These include the effects on the risk premium, on expectations, and on optimal tax smoothing. Against these is the core Keynesian argument that the fiscal multiplier is higher today than it will be later if we believe the economy is operating below potential today. Identifying the optimal fiscal policy requires solving a difficult dynamic cost-benefit calculation with highly incomplete data. But the debate will be better served if we focus on the real elements of the calculation rather than the red herring of compounding debt service costs.