World Public Debt and Real Interest Rates

World Public Debt and Real Interest Rates
by Robert Ford and Douglas Laxton

Aside from perhaps unemployment or inflation, no other recent
macroeconomic policy issue has attracted as much attention as government
deficits. Robert Barro and others have demonstrated that the long-term
effects of government debt on real interest rates will depend on the extent
to which consumers view government debt as wealth. If consumers are
connected to all future generations and can borrow against their future
income streams, changes in government debt will not crowd out private
consumption and investment because consumers adjust their savings to offset
the effects of government deficits on their future tax liabilities. This
invariance proposition is referred to as Ricardian equivalence, although
David Ricardo himself did not believe that the economic consequences of
deficits were unimportant. Although there exists considerable empirical
evidence that rejects the notion that consumers offset completely the
effects of government deficits, there is a paucity of direct empirical
evidence that higher levels of government debt will result in higher real
interest rates. Indeed, a significant body of empirical research, for
example, that by Robert Barro and Paul Evans, has concluded that government
deficits and government debt have not had any significant effects on
interest rates.

This paper estimates the effects of aggregate fiscal developments in
the industrial world on real interest rates in nine industrial countries
with liberalized capital markets. The results imply that the increase in
OECD-wide government debt since the late 1970s was responsible for the rise
in real interest rates in all of these countries. The fact that increases
in government debt in any one country will increase real interest rates in
other countries suggests that some countries with high levels of government
debt may be imposing significant negative externalities on other countries.
The results of this paper have two implications for policy. First, they
suggest that policymakers should care as much about debt targets as they do
about deficit targets. Second, since debt reduction in one country provides
long-term benefits for the world economy, there may be an important role for
coordination of fiscal policies across countries.