This paper by IMF economists Jonathan Ostry, Atish Ghosh and Raphael Espinoza has attracted some media attention. (Flip Chart Rick has a good summary.) I want to talk about it because it does something that is quite rare - it talks about optimal debt policy in the longer run, rather than focusing on the shorter term issues associated with austerity. It also uses theory that I have used in a number of my own papers.
The headline result, that many will find startling, is that countries with what the IMF call ‘fiscal space’ have no need to reduce government debt at all, and should not therefore undertake fiscal consolidation to reduce debt - not today, or tomorrow. By fiscal space they effectively mean that the market is perfectly happy buying the debt, and are not suffering - and are unlikely to suffer - any kind of significant default premium that raises the interest on their debt. The paper suggests that most countries, including the UK, now have this fiscal space (see their page 4).
Many will find this message surprising, particularly coming from the IMF, because we are always hearing about why higher government debt is such a bad thing, and in particular how it imposes such a burden on future generations. However the result the paper is using is perfectly standard in the literature. To put it very simply, high debt does impose a burden, because the taxes required to pay the interest on that debt are ‘distortionary’ - for example income taxes prevent people from working as much as they should. But cutting debt also imposes a burden - taxes have to be raised to get debt down. Analogies between households and governments are misleading: while we as individuals do not live forever and therefore need to pay back debt eventually, the state can act as if it will go on forever. We therefore face a trade-off: is it worth paying higher taxes now in order to reduce government debt so we can pay lower taxes in the future? (Conceptually we can make the same point when talking about government spending cuts.)
The answer to that question depends on two key variables: the real rate of interest and the discount rate: the rate at which we discount utility in the future compared to utility today. In the standard model used by many/most macroeconomists, and used in this paper, these two variables are equal in the long run. If this is the case, it turns out that raising taxes today to cut debt and taxes tomorrow is a net cost, and it is better to leave debt where it is. That is where the headline message of the paper comes from. (Footnote for economists – .)
So suppose an economy suffers a positive government debt ‘shock’ - caused by a financial crisis, for example. The optimal policy is to leave debt higher, if the markets are happy to buy the debt (i.e, there is no additional default premium). The costs of getting debt back down again exceed the benefits. What that means for the UK, for example, is that we should not be going for a zero deficit, but should be happy with a deficit of a little over 3% of GDP that leaves the debt to GDP ratio constant.
Do I agree with this argument? The answer is no and yes.
No, because I think there are good reasons to believe that the real rate of interest on debt is normally a bit higher than the discount rate relevant to social welfare, although I admit this assumption is being put to the test right now (see the secular stagnation debate). If the long run real interest rate does exceed the discount rate, it becomes optimal to aim to reduce debt over time. (Footnote for economists - .)
Yes, because even in what I believe to be the more realistic case, debt is reduced very slowly. As some colleagues and I show in this paper, we could be talking about debt reduction over the period of a century or more. So, in terms of the current policy debate, the standard model used in this paper may be a useful starting point. (Footnote for economists - .)
The paper has plenty of interesting stuff in it. One point that I particularly liked addresses an argument that is often made to defend a rapid reduction in government debt in the UK: we must make room for the next crisis. On pages 12 and 13 the paper goes through a little cost benefit calculation to show why this argument is probably wrong. The paper does not argue that debt should never be reduced in countries with fiscal space. If opportunities arise to reduce debt without incurring significant distortionary costs, they should be taken. The obvious UK example where that was done in the past was the windfall from the sale of 3G spectrum licenses, which Gordon Brown used to reduce debt. The obvious example where that was not done were revenues from North Sea oil, which should have led to paying off public debt and/or building up a sovereign wealth fund as Norway has done. (Please note irony in terms of recent UK politics.)
In terms of the current policy debate, the message to politicians is clear and I suspect pretty robust. The shock of the financial crisis and Great Recession led to a large increase in debt levels in nearly all OECD countries. We should be in no hurry to try and return debt (relative to GDP) to pre-shock levels. That means that we can certainly afford to wait until interest rates have begun to rise, so that monetary policy can offset the impact of any subsequent fiscal consolidation. The case for reducing debt right now has no basis in standard macroeconomic theory.
 This is sometimes called the steady state random walk debt result.
 In this case the optimal long run level of debt becomes negative. So what is called the ‘random walk steady state debt’ result from the paper is a knife edge result: even an epsilon increase in the long run real interest rate leads to a radically different optimal long run debt level. To see why we get this apparent knife edge, see the next footnote.