The long wave of government debt

Andrew Scott 11 March 2010

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One lasting impact of the global financial crisis is that government debt will remain high for decades to come. Forecasts suggest UK government debt will double to reach 94% by 2011 and US debt will rise to 96%. High debt is seen as a serious problem. As Adam Smith warned more than two centuries ago “the practice of funding has gradually enfeebled any state which has adopted it”.

The difficulty with this alarmist view on government debt is that economics doesn’t tell us what is a “high” level of debt. Economic theory only tells us that if the intertemporal budget constraint holds then the value of debt today equals the net present value of future primary surpluses. Without anything more definite it is impossible to say debt is too high or to announce that debt reduction should be an urgent short-term priority. It is true that such huge increases in government debt reflect serious economic problems. But given the enormous financial shock the economy has experienced, we might actually be better off with high debt for a long period of time.

In fact, although economics is quiet on the issue of what it means for debt to be too high it does tell us that in the face of large temporary shocks the optimal response is for debt to show large and long lasting swings. If bond markets are incomplete then we know from Barro (1979) and Aiyagari et al (2002) that debt should act as a buffer to help the government respond to shocks. Marcet and Scott (2009) go further and show that under these circumstances debt should show greater than unit root persistence and much greater persistence than any other variable. In other words, in response to large short term shocks government debt should show decade long shifts. Faraglia, Marcet and Scott (2008) show that these optimal swings may even appear unsustainable for significant periods of time – even though, by design, they are not. Critically, debt is not “mean reverting” – it doesn’t come back down to its previous level.

The logic is simple. The UK and US government have the ability to borrow long term and the option to roll over their borrowing. Rather than abruptly raise taxation and cut government expenditure, fiscal policy should adjust over the long term. Fiscal adjustment in the short run is not enough to produce a surplus and so debt rises for a significant period.

The potential magnitude and duration of these increases in debt can be substantial, but markets have financed much larger levels of debt than are predicted for the UK and US. The largest increases are related to war, but as Japan’s recent experience shows this is not always the case. In the UK between 1918 and 1932 debt increased from 121% of GNP to 191%. It was not until 1960 that debt returned to its 1918 level.

If adjustment occurs over the long run the issue is how is this achieved? Giannitsarou and Scott (2007) study the G7 over the period 1965 to 2008 and find very little seems to be achieved through inflation. Measures of debt, deficit, or general fiscal imbalances have no role to play in forecasting inflation over any horizon. The adjustment instead comes from changes in the primary deficit (the deficit excluding interest payments). In Italy between 1972 and 1997 the average total deficit was 9.6% of GDP and was never below 6%. During this period the primary deficit fell from a high of 8.6% in 1975 to 3.3% by 1989 and to a surplus of 5.4% in 1997. In other words, adjustment is through the primary balance and over a very long time. In the interwar period the UK government only ran a total surplus in 5 years – and even then it was only small in magnitude. But every year between 1920 and 1938 saw a primary surplus that helped check the rise in debt and achieve longer run solvency.

Governments should of course look at long term fiscal solvency and articulate clearly how they intend to achieve debt stability. But forcing governments to achieve specific numerical targets by certain calendar dates is a mistake. If further shocks occur or the crisis continues it will optimal to revise these targets. Debt is the means by which governments accommodate shocks - making policy change to meet previously fixed fiscal targets puts the cart before the horse. Too much current debate takes the form of asserting that fiscal discipline is a good thing. Of course it is. But what markets, credit rating agencies and deficit hawks need to engage in is a realistic debate that recognises that government debt will and should remain at its elevated level for a very long time and the required adjustment is for the long haul. Fiscal discipline and solvency is not inconsistent with decade long shifts in debt. As caustically noted by Macauley, “at every stage in the growth of debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand. Yet still the debt went on growing, and still bankruptcy and ruin were as remote as ever”

Adam Smith may have warned that debt can enfeeble a nation but he also remarked in 1776 that “Great Britain seems to support with ease a debt burden which, half a century ago, nobody believed her capable of supporting”. Debt rose even further in the decades after. Markets and governments in the UK and US have proven before they can support and maintain very elevated levels of debt and should be open to the possibility they can once again.

References

Aiyagari, S Rao, Albert Marcet, Thomas J Sargent, and Juha Seppälä (2002), "Optimal Taxation without State-Contingent Debt", Journal of Political Economy, 110:1220-1254.

Barro, Robert (1979), “On the Determination of Public Debt”, Journal of Political Economy, 64: 93-110.

Faraglia, Elisa, Albert Marcet, and Andrew Scott (2008), "Fiscal Insurance and Debt Management in OECD Economies", Economic Journal

Giannitsarou, Chryssi and Andrew Scott (2007), "Inflation Implications of Rising Government Debt," in: NBER International Seminar on Macroeconomics 2006, National Bureau of Economic Research, Inc.

Marcet, Albert and Andrew Scott (2009), "Debt and Deficit Fluctuations and the Structure of Bond Markets", Journal of Economic Theory

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Topics:  Global crisis

Tags:  default, public debt, public deficit

Professor of Economics, London Business School and Fellow, CEPR

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