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Public debt - How much is too much?

2015-06-04 13:32:59

Jun 3rd 2015, 17:44 by S.K. | LONDON

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Public debt

How much is too much?

Jun 3rd 2015, 17:44 by S.K. | LONDON

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PUBLIC debt in rich countries exploded between 2007 and 2012, rising from an

average of 53% of GDP to nearly 80%. Some people think this is a problem, and

say that governments need to do their best to cut it. But that view has been

challenged in a new paper from the International Monetary Fund, which suggests

that paying down the debt (or in the words of George Osborne, Britain's

chancellor of the exchequer, fixing the roof while the sun is shining ) is not

the most sensible approach.

The IMF's economists reckon that if a government could choose between having

high or low debt today, then all else equal they would (and should) choose the

latter. After all, when debt is high governments have to impose unpleasant

taxes to fund spending on debt-interest payments. These taxes are a drag on the

economy.

But when a government is faced with a high debt load, is it better to impose

austerity and pay it down, or take advantage of low interest rates to invest?

The answer depends on the amount of fiscal space a government enjoys. This

concept refers to the distance between a government s debt-to-GDP ratio and an

upper limit , calculated by Moody s, a ratings agency, beyond which action

would have to be taken to avoid default. Based on this measure, countries can

be grouped into categories depending on how far their debt is from their upper

threshold: safe (green), caution (yellow), significant risk (amber) and grave

risk (red). It is a decent measure of how vulnerable a government s finances

are to a shock.

For those countries with no headroom (in the red or amber zone on the chart),

the IMF s paper is not much use: they need to take action to reduce their

borrowing levels. But for countries well into the green zone (of which America

is a star performer and Britain is a somewhat marginal case), the IMF s

analysis has a clear message: don t worry about your debt.

For these countries, the wonks argue that the costs of raising taxes or cutting

useful spending to reduce debt levels outweighs any benefits. For countries

safely in the green zone, the authors present an example of a country reducing

its debt from 120% to 100% of GDP. They calculate that the expected costs of

the higher taxation (for instance, from the disincentives to work created by

increased tax rates) are likely to outweigh the expected benefits (from the

lower risk of a default in the event of a crisis) by a factor of ten.

What should such countries do instead? The best thing, the paper says, is

simply to let economic growth take its course. In the long run, if the economy

grows more quickly than debt, the burden of it will fall as a percentage of

GDP.

Their analysis is necessarily simplified; they are much more concerned with

long-run dynamics than the effect of borrowing on growth in the short run

(which may often be the more relevant question for governments on time-limited

electoral mandates). But it is a useful reminder that high public debt should

not necessarily cause panic. Indeed, as previous IMF research has shown, the

trajectory of debt-to-GDP ratios can matter more than their overall level.

Often, the fundamental trade-offs between the costs and benefits of borrowing

for investment are underplayed. Perhaps governments should take a more reasoned

look at the roof before rushing in to fix it.