Optimal Debt Policy for Ireland (Warning: Wonkish)

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.    

10 thoughts on “Optimal Debt Policy for Ireland (Warning: Wonkish)”

  1. This was also the period when Barro was pretty shaky on his labour market microeconomics. He’s embedded in the model a strong substitution effect i.e. that you can’t increase taxes because labor supply would crash. But in fact there will be strong income effects and weaker substitution effects than the freshwater economists assume: higher taxes don’t cause labour supply to decline that much, and so it may be optimal to raise taxes as part of a response to a fiscal shock — with a smoother ex post debt path than the Barro paper implies.

  2. I do not wish to disrupt the flow on this post but this will be of interest to the academics who post frequently.

    Corruption is quite rare in Germany so when it occurs they make the most of it. This is a doctoral plagiarism charge that started the witch hunt which led to a government vehicle driven to Spain by one individual and a paternity suit by another. Clearly the media is gunning for Angela.

    The article is by Anna Sauerbrey of Der Tagesspiegel

    Plagiarism hunters also want to check Wankas PhD
    02/11/2013 17:21 clock
    Even before taking office, is Johanna Wanka target of plagiarism hunters. Photo: AP
    Even before taking office, is Johanna Wanka target of plagiarism hunters – Photo:. Dpa

    On Thursday Annette Schavan successor Johanna Wanka in Berlin take over the education department. Plagiarism hunters have now announced that they will also check her thesis.

    Even before the swearing in of the future Education Minister Johanna Wanka ( CDU ) on Thursday announced plagiarism hunters to check their thesis. “I’m going to do, of course,” said the founder of the research network “VroniPlag” Martin Heidingsfelder, the “Hamburger Morgenpost”. He was also the work of Annette Schavan checked.

    The Saturday retired Federal Education Minister Schavan wants the other hand mix this Tuesday at the fools and take part in a carnival parade in their constituency Ulm / Alb-Donau.

    In North Rhine-Westphalia CDU prevails after a report in the “Rheinische Post” annoyance, because the largest national association after the resignation Schavan disregarded in the succession question remained. CDU regional party leader Laschet would discuss it internally, confirmed a spokeswoman for the CDU in NRW dpa request in Dusseldorf. Since the dismissal of Environment Minister Norbert Röttgen in May 2012, the NRW-CDU is only with Chancellery Minister Ronald Pofalla represented in the federal cabinet.

    German Chancellor Angela Merkel had decided on Saturday as the successor to the Initiative for Vanka, who had been at the University of Dusseldorf because of “deliberate deception” when deprived of their doctoral work of PhD. Previously also the North Rhine-Westphalian CDU politician Peter Hintze had been mentioned as a possible successor.

    Regardless of her resignation Schavan will receive in March the Abraham Geiger Prize. The award recognizes contributions to Judaism. Schavan it was thanks to “the Jewish theology after nearly 200 years can finally be established as a specialist at a German university”, said the resident Abraham Geiger College in Potsdam. Schavan have through their commitment “to equality with the Christian theologies and Islam made,” it said.

    Wanka receives on Wednesday their discharge certificate from the Lower Saxon cabinet. On 19 February, the state parliament in Hanover is on the red-green coalition agreements with Stephan Weil (SPD) to elect a new head of government. (Dpa)

  3. The NYTimes article by Anna Sauerbrey is a little dismissive of the PhD problem. I hardly imagine that that university would have withdrawn a PhD because of a few misattributed footnotes only.

  4. Germany and Ireland are like day and night when it comes to corruption.

    In our own minds we can rationalise anything, in Germany a couple of mistakes in footnotes will do you in. It is highly likely that there is nothing else to be found or it would be in the headlines already.

  5. @John McHale

    John, I still fail to see how we can take on a financial system debt of 50% GNP (with no control over exchange rate) and stabilise let alone prosper. The outlook from where I stand is horrendous.

    After last week I believe that the odds on sleepwalking into a full blown sovereign default have shortened considerably. At an EU level the flawed bundesbanke ideology, and an ECB with one hand tied behind its back, are leading the EU into regression and much reduced influence globally both economically and politically. I have now move further towards the Exit end of the spectrum notwithstanding the fact that I fail to see a political will competent to do so.

  6. @JMcH
    I hope you don’t believe too much in the “real truth” of your academic models…! This is a weak posting.

  7. @ Paul W,

    The point that borrowing more now means that less can be borrowed in the future is a strong one. There are various ways of measuring this. One is through higher interest bills forcing higher primary balances to stabilise/reduce the debt ratio when the debt is “high”. This is likely to be a larger concern for current rather than subsequent generations.

    In time the burden of debt interest can be reduced. Ireland’s last “nominal debt shock” reached a zenith towards the end of the 1980s. Over the next 20 years this debt shock was reversed. However, apart from a brief spell in the early 1990s most of the adjustment was achieved by growth and inflation.

    The debt shock was reversed and this was done without any reduction in the nominal level of debt (as is usually the case). That is not to say the cost of the 1980s was zero. In 2007 we still had an annual interest bill of €2 billion. In the run-up to 2007 we could have had €2 billion more primary expenditure and run the same deficits had the debt not been present. This was the legacy of the 1980s but there were very few who were too bothered by it.

    If we didn’t have a €2 billion interest bill (or equivalently a debt of 25% of GDP) as we entered 2008 would we be in the same position now? What space would the absence of that legacy of GDP have afforded us? How could we have used it?

    [A related counter-factual is that if we had a debt of 90% of GDP in 2008 what would have happened?? That’s for another day.]

    Ireland will carry a cost from the borrowing we have undertaken since 2008. The interest bill is already around 5% of GDP a year. By reducing borrowing (as we are now doing) and restraining borrowing (as we have to do in the future) inflation and growth will reduce the interest burden. Unlike Ireland of the 1990s there are countries such as Italy which have not reduced the burden of the debt they have.

    There is unlikely to be a generation that will reduce the nominal government debt barring some positive shock which makes it “cheap”. It is likely that no generation would use their income to pay down government debt to allow a subsequent (and richer) generation to borrow more. But they do hope that the subsequent generation will be sufficiently richer so that the interest burden of the debt is much reduced.

    That is pretty much what the announcements of the last fortnight are based on. This generation have no intention of paying down the debt that has been run up. I don’t believe we intend that future generations will pay it down either. We just hope that the reversal that John is referring to can be achieved by eliminating the deficit in the short term and through assistance from growth and inflation in the long term.

  8. But where do this debt ratio of 60 percent of GDP come from?

    Truth is, it is meaningless number pulled out of thin air. It could be any number.

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