Scholarly knowledge

Government Debt

Is public debt problematic? We read over 50 academic papers to find out and broke it down below to the most important points.

Does public debt inhibit growth?

Low economic growth and high debt-to-GDP-ratios coincide in several countries. However, it remains unclear whether high levels of public debt inhibit growth or whether it is low growth and thus lower GDP that causes higher debt-ratios (e.g. Holtfrerich et al., 2015).

During the course of the financial crisis, it has often been claimed that public debt of more than 60 percent of GDP reduces growth. A debt-ratio of more than 90 percent was considered by some to be detrimental to growth (Reinhart & Rogoff, 2010). Yet, these claims are false and can be traced back to the authors’ methodological errors (Ash et al., 2020). As of today, the data does not justify any conclusions on a growth-inhibiting effect of public debt. Consequently, there is no definitive threshold for such effects.

Especially after crises, increasing public debt coincides with higher growth in the medium term. Ferreira (2016) has confirmed this finding for the 28 EU-members in the aftermath of the financial crisis. For Euro-countries, Baum et al. (2013) reach a similar conclusion on the positive effects of public debt on GDP growth. This is due to the positive economic functions of public debt and the increase in private investment, that follows fiscal spending.

Does debt lead to inflation?

The public tends to associate high public debt-ratios with concern about increasing inflation or even hyperinflation. This is based on the presumption that high levels incentivize the government to use the printing press to reduce its debt burden. The most prominent example of this behaviour is the German hyperinflation 1923.

Whether higher public debt leads to higher inflation in the future depends on how the central bank reacts. As long as the central bank credibly commits to maintaining price stability, no inflation is to be expected (Sims, 2013). If debt levels rise too high, there could be a risk that central banks can no longer increase interest rates without causing fiscal problems. Subsequently, the central bank could refrain from interest rate raises required to reduce inflation (fiscal dominance).

So much for the theory. What does the data say? For the group of developed economies, to which Germany belongs, no association could be found between public debt and inflation (Kwon et al., 2009).

Is there currently a risk of excessive inflation? In order to prevent self-reinforcing inflation and to ensure price stability, the European Central Bank (ECB) has defined an inflation target of below, but close to, 2%. In recent years, inflation remained significantly below 2% despite expansive monetary policy. Currently, inflation tends to be too low rather than too high.

Distributional effects of public debt

A common argument against public debt is that it comes at the expense of future generations onto whom it would be passed. In fact, not only public debt but also ownership of government bonds is passed on. Creditors and debtors tend to be part of the same generation such that the distributional effect between generations is limited (e.g. Holtfrerich et al., 2015). It is crucial how the money is spent because public spending can create lasting value. If public debt is used to fund investment in education, climate protection, digitalization and the like, it benefits future generations.

The distributional effects within a generation are as follows: in times of positive interest rates, funding public spending by issuing government bonds tends to redistribute from the general public towards the wealthy (Nisreen, 2015; Arbogast, 2020). This is because the wealthy can invest some of their money in government bonds and thus receive interest payment from the state. Historically, redistribution from the public to the private sector has led to increased inequality (Piketty, 2014). However, there are also models according to which higher public debt reduces inequality (von Weizsäcker, 2018). In order to evaluate the actual effect of public debt on equality, the funded services need to be taken into account. Most types of public expenditure tend to reduce inequality (education, social services).

Positive economic functions

Regularly, only the negative aspects of public debt are considered despite it fulfilling various essential economic functions.

Borrowing allows the government to balance out cyclical fluctuations (Fuest and Thöne, 2008). To do this, the government borrows in “bad” times to stimulate the economy through additional spending. After all, government spending is always the income of private companies and households, regardless of whether the government pays social benefits or commissions the construction of a bridge. In “good” times, on the other hand, the debt ratio (the ratio of debt to GDP) is reduced by economic growth (in rare cases, the debt ratio is reduced even more by active debt repayment, e. g. in Germany 2014-2019).

This business cycle smoothing is both sensible and necessary since economic crises often lead to significant uncertainty, and only the government can stabilize household and company incomes. Otherwise, more and more people would lose their jobs, and the economy would go into an even deeper recession. In this case, companies would have to look laboriously for new employees. Besides, long-term unemployment often leads to the loss of skills and has a negative long-term effect on economic growth.

In addition to fiscal policy (revenue and expenditure policy), monetary policy can also have a stimulating effect through interest rate cuts during crises. However, the latter is strongly constrained at the effective lower-bound, which is why fiscal policy needs to play a more active role (e. g. von Weizsäcker, 2010).

Public debt enables the state to finance investments that only pay off in the future (Fuest and Thöne, 2008). Provided that the return on these investments exceeds the interest cost of public debt, future generations benefit from them, as the additional revenues can easily offset the public debt. In addition to traditional investments, such as in education or infrastructure, our economy’s decarbonization is an essential and urgent task. Especially in the current low-interest-rate environment, borrowing is an attractive tool for tackling decarbonization cost-efficiently.

Public debt and savings

What happens when public debt is reduced on a large scale? People often forget that, globally, no one can save without someone else incurring the same amount of debt. In Germany, the private sector (households and businesses) is saving. If the government does not offset these savings by taking on debt, foreign countries will have to take on debt. In trade balance, this is accompanied by an export surplus in breach of the European regulation on preventing and correcting macroeconomic imbalances. This export surplus is also causing political tensions.

Over the past decade, interest rates declined steadily. This is due to an ample supply of savings, which is matched by comparatively low demand for loans. According to von Weizsäcker (2013), two main factors are responsible for the current low natural interest rate: an ageing society, combined with the desire to build up savings (for retirement), and companies’ low demand for capital in the digital economy. Von Weizsäcker stressed that paying back public debt would make positive real interest rates impossible. The current low interest rates not only harm people who want to save but also limits monetary policy (Caballero et al. 2015) and, at worst, leads to significant growth losses (Caballero et al. 2017).

Households’ desire to save mainly results in high demand for safe investments, so-called “safe assets.” These are central to the functioning of financial markets. Shortage of safe assets can be a significant growth inhibitor – providing safe assets through the issuance of additional government bonds would have a global growth-enhancing effect (Caballero et al. 2017).

Sustainability of public debt

The absolute public debt level (approx. €2.3 trillion in Germany) is a figure with limited meaning. The government debt level is usually measured by the debt ratio (debt as a share of GDP). It allows national debt to be compared both over time and countries. In Germany, the debt ratio is just over 70% (Sachverständigenrat, 2020). Some authors define sustainable public debt as having a constant debt ratio (Holftfrerich et al., 2015). Repayment of all public debt (i. e., reducing the debt ratio to zero) is neither necessary nor sensible from an economic point of view.

According to Bender and Löwenstein (2015), sovereign debt is sustainable if a country can meet its obligations without suffering economic losses. Another measure of the sustainability of sovereign debt is the ratio of debt-related interest payments to tax revenue. The interest-tax ratio indicates the share of public debt’s cost (interest expenditure) in tax revenues. Between 1980 and 2010, this ratio was more than 10% but has fallen to 2.5% due to the persistently low interest rates (Sachverständigenrat, 2020).

From an economic point of view, the most critical finding is that there is no fixed threshold beyond which sovereign debt would no longer be sustainable, even though the European Fiscal Pact has set a 60% ceiling on the debt ratio (more for historical and political reasons).

The debt ratio’s evolution depends on the real interest rate (r) and the real growth rate (g) of the economy. If the real interest rate (r) rises, the government must bear a higher interest burden on the public debt. This puts a strain on the budget and leads to a higher debt ratio through the additional expenditure. On the other hand, if the economy (g) grows, the debt ratio is reduced. Supposing the real interest rate is lower than GDP growth (r<g), even a moderate budget deficit does not increase the debt ratio. This has been the case in recent years and is also predicted for the coming period (Blanchard et al., 2020; IMF, 2020). Of course, one can only predict the future relationship between real interest rates and economic growth with a given uncertainty.

Additionally, the carrying capacity depends on subjective expectations. If investors’ confidence in the government’s ability to repay debt is eroding, they charge a risk premium. The now higher interest burden weighs on the national budget and may negatively affect the dynamic of rising debt.

Bibliography

Arbogast, T. (2020). Who are these bond vigilantes anyway? The political economy of sovereign debt ownership in the eurozone, In Discussion Paper, Issue 20/2. Max Planck Institute for the Study of Societies. [Online] https://www.mpifg.de/pu/mpifg_dp/2020/dp20-2.pdf [Abgerufen am 28.10.2020]

Ash, M., Basu, D., & Dube, A. (2020). Public Debt and Growth: An Assessment of Key Findings on Causality and Thresholds. In University of Massachusetts Amherst Department of Economic Working Paper(433 (re-issued)). [Online]https://www.peri.umass.edu/publication/item/980-public-debt-and-growth-an-assessment-of-key-findings-on-causality-and-thresholds [Abgerufen am 28.11.2020]

Baum, A., Checherita-Westphal, C., & Rother, P. (2013). Debt and growth: New evidence for the euro area. In Journal of International Money and Finance, 32, 809–821. [Online]https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1450.pdf [Abgerufen am 22.10.2020]

Bender, D., & Löwenstein, W. (2015). Auslandsverschuldung: Tragfähigkeit und Wachstum. In WiSt – Wirtschaftswissenschaftliches Studium, 44, 317–324. [Online]https://www.beck-elibrary.de/10.15358/0340-1650-2015-6-317/auslandsverschuldung-tragfaehigkeit-und-wachstum-jahrgang-44-2015-heft-6?page=1 [Abgerufen am 02.10.2020]

Blanchard, O. J., Leandro, Á., & Zettelmeyer, J. (2020). Revisiting the EU fiscal framework in an era of low interest rates.9. March; Mimeo. [Online]https://ec.europa.eu/info/sites/info/files/s3-p_blanchard_et_al_0.pdf [Abgerufen am 08.11.2020]

Caballero, R. J.,Farhi, E., & Gourinchas, P.-0. (2017). The safe assets shortage conundrum, In Journal of Economic Perspectives31(3), 29–46. [Online]https://www.aeaweb.org/articles?id=10.1257/jep.31.3.29 [Abgerufen am 28.10.2020]

Caballero, R. J. & Farhi E. (2018). The Safety Trap, In Review of Economic Studies85(1), 223-274. [Online]https://economics.mit.edu/files/12658 [Abgerufen am 02.11.2020]

Dullien, S., Paetz, C., Watt, A. & Watzka, S (2020) Vorschläge zur Reform der Europäischen Fiskalregeln und economic governance. In IMK Report 159, Juni 2020 [Online]https://www.imk-boeckler.de/de/faust-detail.htm?sync_id=8945 [Abgerufen 05.10.2020]

Ferreira, C. (2016). Debt and Economic Growth in the European Union: A Panel Granger Causality Approach. In International Advances in Economic Research, 22(2), 131–149. [Online]https://link.springer.com/content/pdf/10.1007/s11294-016-9575-y.pdf [Abgerufen am 02.12.2020]

Fuest, Clemens & Thöne, Michael. (2008). Staatsverschuldung in Deutschland: Wende oder Anstieg ohne Ende? In Discussion Paper, Issue 08/2. FiFo Institute for Public Economics, University of Cologne. [Online] https://www.econstor.eu/bitstream/10419/23273/1/FiFo-CPE-DP_08-02.pdf [Abgerufen am 23.10.2020]

Gechert, S., Horn, G. & Paetz, C. (2017) Long-term effects of fiscal stimulus and austerity in Europe . In IMK Working Paper Nr. 179, Hans-Böckler Stiftung [Online]https://www.boeckler.de/en/faust-detail.htm?sync_id=7815 [Abgerufen am 13.10.2020]

Holtfrerich, C. L. (2015). Staatsschulden: Ursachen, Wirkungen und Grenzen. In Wirtschaftsdienst, 95(8), 529–533. [Online]https://www.acatech.de/wp-content/uploads/2018/03/3Akad_Bericht_Staatsschulden2015.pdf [Abgerufen am 07.11.2020]

IMF (2020). IMF fiscal monitor October 2020. [Online] https://www.imf.org/en/Publications/FM/Issues/2020/09/30/october-2020-fiscal-monitor [Abgerufen am 04.11.2020]

Kwon, G., McFarlane, L. & Robinson, W. (2009). Public Debt, Money Supply, and Inflation: A Cross-Country Study. In IMF Econ Rev 56, 476–515 (2009). [Online]https://ideas.repec.org/a/pal/imfstp/v56y2009i3p476-515.html [Abgerufen am 04.11.2020]

Nisreen, S. (2015). Income inequality and the composition of public debt. In Journal of Economic Studies, 42(5), 821–837. [Online]https://www.emerald.com/insight/content/doi/10.1108/JES-01-2014-0015/full/html [Abgerufen am 10.11.2020]

Piketty, T. (2014). Capital in the Twenty-First Century. In Harvard University Press.

Reinhart, C. M., & Rogoff, K. S. (2010). Growth in a time of debt. In American Economic Review, 100(2), 573–578. [Online]https://scholar.harvard.edu/files/rogoff/files/growth_in_time_debt_aer.pdf [Abgerufen am 05.11.2020]

Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (2020). Jahresgutachten 2020/21. [Online] https://www.sachverstaendigenrat-wirtschaft.de/fileadmin/dateiablage/gutachten/jg202021/JG202021_Gesamtausgabe.pdf [Abgerufen am 15.11.2020]

Shiamptanis, C. (2017) Austerity Measures: do they avert solvency crises? In LCERPA Working Paper No. 2017-6. [Online]http://www.lcerpa.org/public/papers/LCERPA_2017_6.pdf [Abgerufen am 02.11.2020]

Sims, Christopher (2013): Paper Money. In American Economic Review 103, 563-584. [Online] https://oar.princeton.edu/bitstream/88435/pr1pb3n/1/paper%20money.pdf [Abgerufen am 07.11.2020]

von Weizsäcker, C.C. (2010). Die Notwendigkeit von Staatsschulden. In Wirtschaftsdienst, 90(11), 720-723. [Online]https://www.wirtschaftsdienst.eu/pdf-download/jahr/2010/heft/11/beitrag/fiskalpolitik-nach-der-krise.html [Abgerufen am 19.10.2020]

von Weizsäcker, C.C. (2013). Public Debt and Price Stability. In German Econ Rev, 15, 42-61. [Online] https://onlinelibrary.wiley.com/doi/full/10.1111/geer.12030 [Abgerufen am 19.10.2020]

von Weizsäcker, C. C. (2018). Verteilungswirkungen von Staatsschulden. In List Forum Für Wirtschafts- Und Finanzpolitik, 44(2), 143–152. [Online]https://link.springer.com/article/10.1007/s41025-018-0108-8#Sec4 [Abgerufen am 19.10.2020]