Public debt: How much is too much?


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A new paper from the IMF suggests that countries should not pay back debt at expense of growth

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.


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