What does economics say about the optimal response to a positive shock to nominal government debt – say an increase due to the costs of funding a bank bailout or an increase that results from automatic stabilisers in a recession? From many recent statements I have seen, there seems to be something close to a conventional wisdom that the increase in the debt does not have to be reversed. It is only necessary to increase the primary surplus to pay the interest on the higher debt, or, even better, to fund the difference in the nominal interest and nominal growth rate times the increase in debt.
The logic for this position comes from Robert Barro’s classic tax smoothing paper (Barro, 1979). Given that distortions rise non-linearly with the tax rate, Barro shows it is optimal to maintain constant tax rates over time for a given path of government spending. A surprising implication is that a shock to the debt to GDP ratio should be accommodated in the sense that the ratio should be allowed to rise permanently. This leads to the optimal debt ratio to follow a “random walk”, allowing the ratio to be pushed around by debt shocks. (See Section 2 of this paper for a nice exposition.)
But is this result too comforting? As Simon Wren Lewis has pointed out in a number of insightful posts and papers (see here and here), the result depends on Barro’s assumption of altruistically linked generations. The result does not hold in an overlapping generations (OLG) model where the interest rate is greater than the discount rate due to the limited concern for future generations. In this model, optimal debt policy does require that the increase in the debt ratio is reversed, although the optimal timeframe for the reversal can be very long. (Simon is at pains to note that this should not stop the use of countercyclical policy in a recession.)
Another critical implicit assumption in the Barro model is that the Government’s creditworthiness is not an issue. This may be a reasonable assumption for a country such as the US that has its own central bank, which could print money to avoid default in extremis. But recent experience has taught a hard lesson about the fragility of creditworthiness in an economy such as Ireland’s. Suppose that the debt to GDP ratio has to be below, say, 80 percent of GDP to ensure robust creditworthiness. For a given path of nominal GDP, the increase in nominal debt due to the shock will have to be reversed – and possibly quite quickly. (This does not necessarily mean that nominal debt will actually have to be cut; but increases in nominal debt that would have been feasible due to nominal GDP growth must now be foregone.)
Finally, the result does not allow for rules on the maximum allowable debt to GDP ratio. Under the SGP and fiscal treaty, the maximum allowable debt ratio is 60 percent of GDP. Again, any shock to the nominal debt will have to be reversed, even if the time frame under the rules for bringing the debt ratio to the target can be fairly long.
The bottom line is not a welcome one. Nominal debt shocks have to be reversed (eventually), not accommodated.