When Is Repaying Public Debt Not Of The Essence?

IMF Blog, June 2, 2015

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Financial bailouts, stimulus spending, and lower revenues during the Great Recession have resulted in some of the highest public debt ratios seen in advanced economies in the past forty years.
Recent debates have focused on the pace of debt reduction, with insufficient attention to whether debt needs to be paid down at all.
From a welfare economics perspective—abstracting from real world problems such as rollover risk—doing nothing and simply living with the debt would be optimal.
Some countries clearly need to bring down debt; others can fund themselves at exceptionally low interest rates and could allow their debt ratio to decline organically through growth or windfall revenues.

Tax-smoothing principle (Robert Barro): constant tax rates are efficient because distortionary costs are typically convex—rising at a faster rate—with the tax rate.
The economic burden of public debt is the distortionary cost associated with the taxes needed to service it; once incurred (short of default) it is effectively sunk and unavoidable.
Temporarily raising taxes to repay debt—and later lowering them—can create additional distortions without welfare benefits.

Three principal objections are identified:
- (i) In some countries, debt is dangerously high and there is risk of a funding crisis.
- (ii) Debt is bad for growth and therefore should be paid down.
- (iii) There may be large fiscal shocks in the future, so it is sensible to build up buffers against them.
Each objection is potentially serious and requires careful consideration; none is dismissed outright.

Countries’ debt levels can be usefully thought of as falling into three zones:
- Green zone: fiscal space is ample.
- Yellow zone: fiscal space is positive but sovereign risks are salient.
- Red zone: fiscal space has run out.
Policy implications by zone:
- Red zone (and possibly yellow): debt sustainability constraints leave few options; countries need to focus on bringing the debt down. Example cited: Greece.
- Green zone: sovereigns can fund themselves at reasonable—or even exceptionally low—interest rates, with no real possibility of a debt-induced sovereign crisis; living with debt and allowing the debt ratio to decline organically may be preferable to deliberate repayment.
Cost-benefit rationale:
- The benefit from repayment is small for countries with ample fiscal space because sovereign debt crises are rare and the probability curve is very flat in the debt level—crisis risk hardly falls when debt is reduced from, say, 120 to 100 percent of GDP.
- The cost of reducing debt can be much larger: distortionary taxes or cuts in productive spending required to run a budgetary surplus can have a deleterious permanent effect on the capital stock, output, and consumption. Costs rise steeply if adjustment is faster.

Servicing public debt requires distortionary taxation, which reduces incentives for capital and labor and leads to lower private and public capital stocks and lower growth.
However, paying down debt is not necessarily pro-growth because the adjustment process (higher taxes or spending cuts) can itself depress investment and growth—the cure may be worse than the disease.

Lower debt increases the option value of fiscal space in the face of catastrophic events (for example, a financial crisis requiring a public backstop).
If debt is high when a shock occurs, sovereign risk premia may rise sharply and markets may even shut out the sovereign.
Even for green-zone countries, building buffers has merit, but it is a matter of balance: reducing debt at the cost of investment and output may render the margin illusory.
Recommendation: the nominal value of the debt should not necessarily be paid down; instead the debt ratio should be allowed to decline organically.

Not all advanced economies face the same fiscal situation: some must reduce debt urgently, others face ambiguous risks, and a few have ample fiscal space.
Determining a country’s zone is not mechanical; it requires judgment based on stress testing fiscal balance sheets to withstand extreme shocks.
The blanket mantra that it is always desirable to reduce public debt should not go unquestioned.
For countries in the green zone, the case for living with the debt is strong, subject to careful cost-benefit analysis and consideration of unexpected contingencies.

Source: Jonathan D. Ostry and Atish Rex Ghosh, "When Is Repaying Public Debt Not Of The Essence?", June 2, 2015.

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