Transcript of a Conference Call on the Publication of the SDN, When Should Public Debt be Reduced?

June 3, 2015

Washington, D.C.
Tuesday, June 2, 2015

Ismaila Dieng, Communications Department
Jonathan Ostry, Deputy Director, Research Department
Rex Ghosh, Assistant Director, Research Department

MR. DIENG: Thank you. Good morning everybody and welcome to this conference call on our new staff discussion note, When Should Public Debt be reduced? Mr. Jonathan Ostry, Deputy Director of the IMF’s Research Department and the lead author on this paper will have opening remarks. You have received the paper and the blog under embargo. The embargo will be lifted at 10:30. So without further ado I’ll hand it over to Jonathan, and then he will be happy to take your questions.

MR. OSTRY: Thanks very much, Ismaila, and thank you all for joining this call. So we’re releasing, as Ismaila said, a paper and a blog today on a controversial and relevant issue. Under what circumstances would countries want to deliberately pay down the public debt that has been run up during the global financial crisis?

There’s sometimes a feeling that what goes up must be brought down, and brought down through deliberate policy action. In the fiscal sphere a popular mantra is that, to the degree that public debt has surged following the global financial crisis, it needs to be brought down to more prudent levels. High debt is risky and can, in the bat of any eye, lead markets to charge sky-high lending rates or even shut the sovereign out of the market altogether. High debt is also bad for growth, so the argument goes. This is controversial, since causality can run both ways, but certainly, if servicing the debt requires higher taxes, then a hit to growth is not farfetched.

High debt also leaves little margin for unexpected disasters or financial crises. Getting wet on a rainy day is rarely pleasant; much better to invest in an umbrella in sunny times. An ounce of fiscal prevention is easily worth a pound of fiscal austerity during a crisis.

Taking out insurance can be a good idea for many risks, but insurance has a cost, and people will generally compare the cost and the benefits before deciding to buy or not. So is deliberately running a budgetary surplus to pay down public debt always a sensible policy? As a matter of economic logic, the answer is obviously no. The net benefit of insurance need not be positive for all countries at all times. Just as we don’t buy insurance for everything, we shouldn’t either have a knee-jerk reaction to pay down the public debt as insurance against future risks.

Take a country that, while it may have quite a bit of debt, faces very low borrowing costs and for which there is very little real prospect of a sovereign crisis. The benefit of insurance for such a country is likely to be small. In the cross-country evidence, fiscal crises are rare events and, more important, the crisis probability curve is very flat in the level of public debt. A fiscal effort today will reduce the probability of a crisis a little, but the payoff is likely to be very small, and our paper quantifies what “very small” means.

This isn’t true of countries that may be in a yellow or red zone in terms of available fiscal space, for which sovereign risks are salient or fiscal space has run out altogether. For countries in this boat, the payoff to reducing debt could be very high indeed.

My remarks, so far, have focused on the crisis insurance benefit of repaying debt, but what is the cost of this insurance? When a country runs a budget surplus to pay down its debt, there is no free lunch. The money has to come from somewhere, either higher taxes, which undercuts the productivity of labor and capital, or lower spending which, unless that spending is completely wasteful, has a similar effect.

Sometimes the debate seems to assume that the insurance acquired through lower debt is free. The way the argument is often cast, advocates of ‘fixing the debt problem’ stress the crisis insurance benefit of lower debt without mentioning the upfront cost of the insurance. Our paper shows that insurance can be expensive in terms of the higher taxation needed to run a budget surplus, and, more important, that for countries that have ample fiscal space, the cost of insurance is likely to be much larger than the benefit.

It’s much better in these circumstances to simply live with the debt, allowing the debt ratio to be reduced organically through higher output growth. Economic welfare, in fact, is likely to be significantly higher when a country chooses to live with the debt, letting the debt ratio decline organically through growth, than if it chooses to pay down the debt or even build up assets to save for a rainy day.

There’s one further aspect of the issue that bears highlighting. People often claim that debt must be paid down to lay a firmer foundation for economic growth. This is a fallacy. Debt is, indeed, bad for growth, but the growth cost of high debt is a sunk cost, and that cost is only amplified if countries take steps to raise taxes today to pay down the debt only to lower them again tomorrow once the debt is down.

The bottom line is a simple message. When fiscal space is ample, policymakers should not obsess about paying down the debt. Living with the debt may be the better policy. So my co-author Rex Ghosh, and I are happy to take your questions.

QUESTION: Hi, yes. Thank you for doing this. How would you respond to the concerns about government debt crowding out private investment? It seems to be essential here.

MR. OSTRY: So basically, when there is higher debt and you’re at full employment I think concerns about crowding out are salient. When you are facing a situation of unemployed factors of production, very low borrowing costs, I think one would be very much less concerned about the crowding out issue. One might go further and say that a buildup of public capital in circumstances [of unemployed resources] might actually crowd in private investment, and there might be a virtuous cycle rather than the kind of vicious cycle that one worries about in a situation of normal real interest rates and full employment.

QUESTION: Okay, thank you. Secondly, can you name some prime candidates for this principal? Is the U.S. or Germany -- are they good candidates?

MR. OSTRY: So, this paper is not in the realm of what at the Fund we call bilateral surveillance. We’re not trying to say which specific countries are in the different red, yellow, or green zones identified in the paper.

The issue is more an analytic one. If a country, notwithstanding that it may have quite a bit of debt, has a very good track record or servicing that debt, and is viewed by markets as a very safe risk, we say it has ample fiscal space. A country such as Germany might well be in such a ”green zone.”

We defined the concept of “fiscal space” in an earlier note five years ago, that I think you may have covered at the time, and Moody’s has since adopted our methodology in its assessments of sovereign risks for advanced countries. We listed a table from the Moody’s website as Figure 1 in the paper.

They have their own take on where countries fall in the different zones. We reported those numbers in the paper. If you go back to our 2010 paper, you will see our own numbers from that time but we have not updated them to 2015. And more importantly, it is in any case the bilateral surveillance documents, the Article IV reports, that you would turn to for the official IMF view of whether fiscal space is ample, moderate, or dangerously low.

QUESTION Hi. Thanks for doing this. I was wondering if you could elaborate a bit more about markets and how they perceive debt limits. Because it seems like in the past IMF has set, kind of, lines for that, you know, 120% debt to GDP is too high because markets will react to that. And I’m just wondering how that plays with your analysis? I mean, it seems like it’s kind of hard to gauge where that is for countries. I mean, the U.S., obviously, struggles with where that line is more, kind of, politically and that sort of thing. Thank you.

MR. OSTRY: Thank you very much for your question. It is very hard and I don’t want to diminish the difficulty of making these judgments. As we say in the paper, this is not a mechanical exercise. A lot of things have to be brought to bear, and ours is one method and hopefully one input into arriving at judgments on these thorny issues.

That being said, I think a key issue in this area is whether the country is likely—in the view of markets—to satisfy its inter-temporal budget constraint. There can be big runups in debt—think of the high debt that the United States had in the aftermath of the second World War—without markets being concerned. What I think markets look to in making judgments is whether there’s an expectation based on the actual track record of the sovereign that these higher debt ratios will come down after they go up.

Green-zone countries are those that, time and again, when the debt ratio has gone up, it has come down again. We want to get away from the idea that the level of debt is a sufficient statistic for how much fiscal space a country has. It’s more its historical track record with respect to the ups and downs of the debt ratio that matters.

We would like to move away from the notion that there is always a debt problem that needs to be fixed, simply because debt is high. That isn’t always the case, particularly for countries that have ample space. Not to diminish, either, the flip side that for those where there is very little or no fiscal space there can be huge payoff from fiscal consolidation. So it cuts both ways.

QUESTION: And I guess -- I mean, we’ll use, for example, use Japan as very grave risk for debt, but in the past markets have not seen that, so I guess that’s something that’s shifted. Do you think that that is tied to the debt levels again or is that just separate? I mean -- yeah, I guess it’s the same questions. It’s hard to estimate when markets change.

MR. OSTRY: Well, again, the IMF’s views on Japan’s fiscal situation are well discussed in the latest Article IV, but Japan is a country that can borrow very cheaply, so there is no sign right now of fiscal distress and fiscal risk. But it also is a country that has a very, very high debt ratio, and that has not reacted in the past in the way that one might expect, that is by running a larger primary balance in response to rising debt. We haven’t seen that in Japan.

MR. GHOSH: Rex Ghosh speaking. I just wanted to elaborate a little bit on what Jonathan was saying. In our earlier paper we talked more about fiscal space. Just a couple of points. One, indeed, it is quite a complex, and not a mechanical exercise. Many factors come in. For example, is the debt held domestically or is it foreign debt? Whether you have your own currency. And there are many factors that would ultimately bear upon how the market perceives the debt level. Whether you have a credible medium-term fiscal strategy for bringing down or stabilizing the debt ratio. All these factors would be reflected in how the market perceives the available fiscal space.

QUESTION: Hi. Thanks for doing the call. Jonathan, you made mention in your opening remarks you said there was no free lunch and spending cuts had a similar effect as higher taxes. Here in the UK we are pursuing aggressive deficit reduction. I wanted to see how you -- any specific comments on the UK economy itself.

MR. OSTRY: Thank you for your question. You’re not going to be surprised that I’m going to punt the aspect that’s specific to the UK. But I will take up your point about the free lunch. So the point we were making is that people who believe that there is a public debt problem that needs to be ‘fixed’, even in cases where there’s very little prospect of sovereign risk, sometimes seem to ignore the cost of bringing the debt down. We want to emphasize that, indeed, there is a cost to bringing down the debt, as there is for all insurance.

Now, of course, if there’s unproductive public spending, then there is a free lunch in some sense. If you can get rid of waste, you should do so. But in a normal environment with full employment, normal interest rates, and where taxation distorts some marginal decision of economic agents, there is no free lunch. That is a world worth thinking about, and for which policy advice is needed.

QUESTION: Is there a bigger cost to higher taxes than lower spending than -- cause you say if it is wasteful spending than yes, okay. We can celebrate and have our free lunch. Is it more harmful to raise taxes than cut spending?

MR. OSTRY: We don’t do comparative simulations in the paper. We assume that the adjustment is done through taxation which affects employment and investment. We have complementarity between public capital and private capital and cutting public investment or raising distortive taxation is costly—both are costly.

MR. GHOSH: This is Rex Ghosh. Just to elaborate one point. We don’t focus on, sort of, Keynesian effects here, so we’re not counting the sort of cyclical cost of fiscal adjustment. And a flipside to what Jonathan was saying is that when there are revenues associated, for example, with, you know, an asset price boom, a housing price boom, then those revenues should be saved and used for reducing debt.

QUESTION: Hi, yes. Isn’t the big problem with this that it’s while academically rational it’s politically impractical, and that’s why we have the problem of 240% of debt to GDP projections for Japan? We have debt to GDP -- a six year debt crisis in Europe, and potential schisms in the U.S. markets.

MR. OSTRY: So, Ian, you’re correct to allude to the so-called debt bias that people often talk about. That’s a well-recognized point and you’re completely right to bring it up.

We are seeing, however, in other countries, a different risk, what one might call “debt obsession.” That basically even though there is a good track record of servicing the debt and ample fiscal space, there is a perceived need to bring the level of debt down, rather than see the debt ratio resolve itself through growth (the denominator). And so we simply want to say that for some countries it is better not to obsess about the numerator. You will do something more costly for the welfare of your citizens if you obsess about the numerator than if you do not. And so that is the point. It’s not to deny the debt bias, which has been operative in the examples you mentioned in your question.

MR. DIENG: If you don’t have any further questions this will bring an end to our conference call. Thank you all for joining us today.


Public Affairs    Media Relations
E-mail: E-mail:
Fax: 202-623-6220 Phone: 202-623-7100