The optimal speed of debt correction

                This month’s Economic Journal sees the publication of a paper by Tatiana Kirsanova and myself that asks how quickly fiscal policy should respond to excess government debt. It is a very topical issue, but we started work on it back in 2004. It was Tanya’s idea so she deserves the credit for any foresight.

                The set up is both straightforward and not too unrealistic. We assume that monetary policy pursues an optimal policy, and that it has the credibility to commit. (We ignore the zero lower bound problem - it is not that topical!) In contrast, fiscal policy involves a simple feedback rule: following some shock, either government spending or taxes are adjusted by some proportion of the level of excess debt. The economic model is of a pretty standard New Keynesian variety. We also ignore the possibility of default on debt. Following various shocks, we look at how social welfare changes as the speed of fiscal feedback varies. The idea was not just to find out what the optimal degree of feedback is, but also to observe how much welfare suffers if we depart from this optimal speed.

                One extreme case is where there is no fiscal feedback – the fiscal authorities just ignore debt completely. The presumption might be that this would lead to an explosive debt spiral. In fact it does not, because monetary policy manages to control both debt and inflation. The way it does this is clever (remember policy is optimal, so it can be clever). Following a shock that raises debt, it first cuts interest rates, which helps get debt under control. It subsequently raises interest rates, which controls inflation. The reason this works is that the inflation process, unlike the government’s budget constraint, is very forward looking – the model is New Keynesian. With rational expectations, promises of higher interest rates in the future help control inflation today, while lower interest rates today keep debt under control. (Those who follow such things may detect an element of the Fiscal Theory of the Price Level here.) However, although the economy is stabilised, inflation is not controlled very efficiently, and so the welfare costs of the shock are high.

                At the other extreme is where fiscal feedback is very rapid: government spending (say) is cut very quickly in response to a shock that raises debt. This does better in welfare terms, but it is not the best policy for two reasons. First, quickly cutting government spending has costs. Second, large changes in government spending mess with inflation. If a shock raises both debt and inflation, you might think this is a good thing, but in this type of model monetary policy is better at controlling inflation than fiscal policy. Having both fiscal and monetary policy control inflation actually reduces welfare.

                The best amount of fiscal feedback turns out to involve pretty slow correction of debt. Although this is an important result, it was not unexpected or very new. This is because the ideal fiscal policy (when both monetary and fiscal policy are jointly determined in an optimal manner under commitment) in this type of model would not eliminate excess debt at all. It is better to allow debt to change permanently as a result of a shock: although this means either government spending or taxes will have to change permanently to finance this debt, the discounted costs of this are less than the large short term changes in fiscal policy required to eliminate all excess debt. (This is an implication of Barro’s famous tax smoothing result.) A simple feedback rule cannot duplicate this ideal policy exactly, but it can get pretty close by not reacting very much to excess debt.

                The result that it is best to correct debt very slowly is neither surprising nor unusual – a similar conclusion is reached by most papers that look at this issue. In that sense it is a robust result. In more recent work that I have done with Campbell Leith and Ioana Moldovan, where the ideal policy is no longer to accommodate shocks to debt, we still get very slow adjustment. The more interesting result in the paper is quantifying the degree to which welfare deteriorates when we try and correct debt too quickly. Controlling debt too quickly is never as bad as not controlling it at all, but it is significantly worse than more gradual adjustment. Trying to correct debt too rapidly is costly, and should be avoided if possible, even when we are not at the zero lower bound.

                One interesting result that surprised me at the time was how well the simple feedback rule for fiscal policy did compared to the ideal fiscal policy (i.e. a joint optimisation benchmark). I now know that this reflects a fundamental property of this basic New Keynesian model, which is that in many cases, and in the absence of the zero lower bound, monetary policy is all you need for stabilisation of output and inflation. (This is well known for demand shocks, but it turns out to be more general than that.) With the help of Fabian Eser and Campbell Leith, we show this analytically here. Of course if monetary policy is compromised by hitting a zero lower bound for nominal interest rates, this result no longer holds. In this case you would want fiscal policy to help out on output stabilisation, as Gauti Eggertsson has examined in a number of papers. The position is similar to that of an individual economy in a monetary union. Tanya and I showed in joint work with Mathan Satchi and David Vines that the simple feedback rule on debt should be supplemented with additional terms reflecting this dual role in a monetary union.

                About two years ago, there was a debate via letters to newspapers over how quickly UK debt should be brought down. I’m told that when one of the economists who signed the ‘cut quickly’ letter saw Tanya present this paper, they said that they now understood why I had signed the ‘cut slowly’ alternative. And for those who would say ‘ah yes, but slow correction would not be credible’, read this.