Question

the implications of rising public debt on the future of a given country?

Answer 1

The future profile of public debt presents major risks and challenges for both fiscal and monetary policy. Here we focus on the real implications of living with a higher level of debt, and turn to challenges facing monetary authorities in the next section. When a country starts from an already high level of public debt, the probability that a given shock will trigger unstable debt dynamics is higher. This risk is increased when public debt is already on a steep upward trajectory, as it is now in several countries. Knowing this, we would expect investors to demand a higher risk premium for holding the bonds issued by a highly indebted country. Studies of the impact of debt on risk premia are rather limited for advanced economies. What evidence there is suggests that the impact is relatively small. For each percentage point of additional public debt, researchers estimate a risk premium increase of between 1.2 and 1.6 basis points.16 With the advent of the market for credit default swaps (CDS), We now have an additional source of information about investor attitudes towards highly indebted advanced economies. Data plotted in the top left-hand panel of Graph 6 allow the unsurprising conclusion that CDS spreads, and hence credit risk premia, are positively correlated with debt/GDP ratios. But we note that there is substantial heterogeneity, suggesting that other factors are important as well. For example, the higher the fraction of debt that is short-term, the lower the risk premium (Graph 6, lower left-hand panel). A higher ratio of incremental debt to private saving (lower right-hand panel) is associated with a higher risk premium. And risk premia are generally lower for countries with a high average revenue share in GDP (top right-hand panel). In addition to higher risk premia and increased cost, a second risk associated with high levels of public debt comes from potentially lower long-term growth. A higher level of public debt implies that a larger share of society’s resources is permanently being spent servicing the debt. This means that a government intent on maintaining a given level of public services and transfers must raise taxes as debt increases. Taxes distort resource allocation, and can lead to lower levels of growth. Given the level of taxes in some countries, one has to wonder if further increases will actually raise revenue.19 The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital. This not only lowers the level of output but, since new capital is invariably more productive than old capital, a reduced rate of capital accumulation can also lead to a persistent slowdown in the rate of economic growth. In an open economy, international financial markets can moderate these effects so long as investors remain confident in a country’s ability to repay. But, even when private capital is not crowded out, larger borrowing from abroad means that domestic income is reduced by interest paid to foreigners, increasing the gap between GDP and GNP. Last but not least, the existence of a higher level of public debt is likely to reduce both the size and the effectiveness of any future fiscal response to an adverse shock. Since policy cannot play its stabilising role, a more indebted economy will be more volatile. This was evident during the latest crisis. Countries saddled with very high levels of public debt did not expand fiscal policy as much as other countries. And, although these countries benefited somewhat from the effects of foreign fiscal expansion, a larger domestic fiscal stimulus could have helped to reduce the severity of the recession actually experienced.