Is there an optimal debt-to-GDP ratio?

A commentary in the VoxEU Debate Development and the crisis

Posted By Anis Chowdhury, The University of Western Sydney, Australia on 9 November 2010

Is there an optimal debt-to-GDP ratio?
Anis Chowdhury and Iyanatul Islam[1]
In current debates on fiscal consolidation, proposed prudential limits on public debt-to-GDP ratios play a crucial role. Such benchmarks typically emanate from technical work undertaken by IMF staff, although it does not necessarily follow that these benchmarks are officially endorsed by the IMF. How robust are the proposed prudential limits on public debt-to-GDP ratios? Should they be treated as optimal in designing fiscal policy? These are the issues that are explored in this paper.

A debt-to-GDP ratio of 60% is quite often noted as a prudential limit for developed countries.[2] This suggests that crossing this limit will threaten fiscal sustainability. For developing and emerging economies, 40% is the suggested debt-to-GDP ratio that should not be breached on a long-term basis. Based on these benchmarks, an April 2010 report by the Fiscal Affairs Department of the IMF[3] offered illustrative ‘fiscal adjustments’ that would be required for developed countries and developing and emerging economies to reach suggested public debt-to-GDP ratios by 2030.[4] Thus, there is a tendency to treat these benchmarks for debt-to-GDP ratios as “optimal” in the specific sense that crossing these thresholds poses threats to debt sustainability. This is consistent with the IMF’s global macroeconomic model which assigns a dual role to fiscal policy: (1) smoothing out business cycles in the short run; (2) meeting targets for debt sustainability in the long run.[5]

Are these benchmarks really optimal? The 60% figure was one of a handful of targets European governments set at the start of the 1990s to prepare for economic and monetary union and the eventual formation of the euro zone. There was no hint of optimality; it was the median debt-to-GDP ratio. The IMF paper does not explain the basis for the suggested benchmark for developing and emerging economies. However, one can find some clue in the 2002 ‘sustainability framework’ of the IMF which notes “ external debt ratio of about 40 percent provides a useful benchmark” (p. 25).[6] In interpreting this benchmark, the authors of the report issue an important caveat: “… it bears emphasizing that a debt ratio above 40 percent of GDP by no means necessarily implies a crisis – indeed … there is an 80 percent probability of not having a crisis (even when the debt ratio exceeds 40 percent of GDP).”

The authors of a September 2010 IMF study on fiscal space emphasizes that the debt limit found in their research “is not an absolute and immutable barrier ... Nor should the limit be interpreted as being the optimal level of public debt.”[7] According to this study of 23 advanced countries, the estimated debt limits, using the historical interest rate–growth rate differential, range from about 150 to 260% of GDP, with a median of 192%. The study assumes that interest rate–growth rate differentials are generally projected to be less favourable than the historical experience, and finds the corresponding median long-run debt ratio to be 63% of GDP and the median maximum debt ratio to be 183% of GDP.

Yet, they conclude, “prudence dictates that countries target a debt level well below the limit” on the ground that “the limit delineates the point at which fiscal solvency is called into question.”  Two key factors affecting solvency are the response of primary balance (i.e., the budget balance net of interest payments on the debt) to increases in debts and the possibility of adverse shocks. It is assumed that when debt gets very large, it may be difficult to generate a primary balance that is sufficient to ensure sustainability, and that shocks can push countries beyond their debt limit. So, the advice is to remain well below the limit for the sake of prudence. This advice is not derived from the analysis of liquidity/rollover risk. Liquidity is not an issue for domestic debt as it can always be paid off by printing money, a sovereign right which households or firms do not have.

In 1988, Belgium had the highest public debt; that position is now filled by Japan, whose debt rose from below 60% in 1988 to 170% of GDP in 2007. Italy’s debt also shot above 100% of GDP during this period.[8] None of these countries experienced spiraling inflation or very high interest rates as is commonly feared when government fiscal deficits rise. Japan is facing just the opposite – deflationary pressure and a zero interest rate. The higher debt-to-GDP ratio in Japan is partly due to very low inflation. A higher, but still moderate, inflation rate will raise nominal GDP and lower the public debt-to-GDP ratio unless there is an actual increase in the government’s gross liabilities.

As long as there is spare capacity in the economy or unemployment, higher fiscal deficits add to purchasing power and do not exert any upward pressure on interest rates or inflation, nor do they cause large current account deficits. However, it is often claimed that higher public debt today has to be paid by higher tax tomorrow. This is not necessarily true. As long as the interest on the debt is less than the annual increase in nominal GDP, the debt need not be repaid because it will be a shrinking fraction of GDP. This was pointed out more than half a century ago by Evsey Domar (1944: 822), “the problem of the burden of debt is essentially a problem of achieving a growing national income”.[9]

Evsey Domar again emphasized after 50 years, “the proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP…’ (Domar 1993: 478).[10]

Yet, the debate on debt continues. It is argued that high debt-to-GDP ratios cause macroeconomic instability which is not good for growth and hence make debt unsustainable. However, a careful scrutiny of the data based on which this claim is made shows that the relationship between debt-to-GDP ratio and macroeconomic instability is weak. Figure 4 (p. 67) of the IMF Fiscal Monitor, May 2010 confirms this.

The claim that high public debt causes lower growth is also not grounded in robust empirical evidence as can be seen from Figure 1 (p. 63) of the same IMF source. The weak relationship is driven by extreme values or outliers. A July 2010 IMF study of 38 developed and developing economies for the 1970-2007 period found that the elasticity of growth with respect to debt is only -0.02.[11]  The same study found that the elasticity of growth with respect to other variables (such as initial years of schooling which contributes positively to growth) is much higher (the size of the elasticity coefficient on schooling is well in excess of 2.0). Hence, the growth-inhibiting effects of a given percentage increase in debt-to-GDP ratio can be easily overwhelmed by a given percentage increase in growth-promoting variables achieved through public spending. This is why it is important to look at the composition of debt, instead of just focusing on the aggregate value of debt.

The issue, however, is different when it comes to the accumulation of external liabilities. The question is then not only of being able to repay, but also whether other countries would be willing to continue to lend. Paradoxically, in crisis-hit countries with access to private capital markets, fiscal prudence does not offer any safeguard against the pitfalls and perils of private sector-led accumulation of external liabilities because they eventually become the liabilities of the government. This is a lesson that Bulgaria and other countries have painfully discovered today in the wake of the Great Recession of 2008-2009 and as Indonesia and Thailand discovered during the 1997 Asian financial crisis.

The current preoccupation with identifying prudential limits on public debt-to-GDP ratios have had the consequence of distracting attention from the crucial role that fiscal policy plays in promoting growth and development. This point is made forcefully in an insightful ‘interim report’ that informed the deliberations of the Development Committee of the IMF and World Bank in April 2006. The authors of the report note that debts and deficits are useful indicators for ‘…controlling the growth of government liabilities, but (they) offer little indication of longer term effects on government assets or on economic growth. Conceptually, the long-term impact is better captured by examining the impact of fiscal policy on government net worth’. The report argues that ‘…there is clearly a need for fiscal policy to incorporate, as best as possible, the likely impact of the level and composition of expenditure and taxation on long-term growth’…[12]

Of course, governments across the world must uphold the principle of fiscal sustainability. At the same time, they should guard against succumbing to the allure of the seeming accuracy of numerical limits on debt-to-GDP ratios.

[1] Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. Iyanatul Islam, ILO, Geneva and Griffith University, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or the ILO.

[2] On average, public debt rose from 60% of GDP on the eve of the crisis (end-2007) to almost 75% by end-2009. IMF country teams project debt ratios to continue rising over the next five years, averaging more than 85% of GDP by 2015. Japan’s public debt is expected to reach nearly 200% of GDP in 2010. Portugal, Italy, Ireland and Greece all show projected 2010 public debt above or headed for 100% of GDP, with Italy leading the pack at 127%, Greece at 120%, Portugal at 90% and Ireland at 65%.

[3] IMF (2010). “From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies”, April 30 (pp7-8).

[4] ‘Fiscal adjustments refer to improvements in the cyclically adjusted primary balance needed to achieve the illustrative gross general government debt target’ (p.9).

[5] Kumhof, Michael, Douglas Laxton, Dirk Muir, and Susanna Mursula (2010). “The Global Integrated Monetary and Fiscal Model (GIMF) – Theoretical Structure”, February, IMF Working Paper (10/34), p.45. The authors of GIMF arrive at ‘calibrated debt-to-GDP ratios’ that range from 50 to 60%% (Table 7), noting that they are ‘roughly in line with the data’ (p.52).

[6] IMF (2002). “Assessing sustainability”, May 28, Washington D.C

[7] Ostry, Jonathan D., Atish R. Ghosh, Jun I. Kim, and Mahvash S. Qureshi (2010). “Fiscal Space”, IMF Staff Position Paper, SPN/10/11, September 1(p.3).

[8] OECD Observer No 270/271 December 2008-January 2009

[9] Domar, Evsey D. (1944). “The ‘Burden of the Debt’ and the National Income.” American Economic Review 34(4): 798-827

[10] Domar, Evsey D. (1993). “On Deficits and Debt”, American Journal of Economics and Sociology 52 (4): 475-478

[11] Kumar, Manmohan S. and Jae-joon Woo (2010). “Public Debt and Growth”, IMF Working Paper, WP/10/174 (July)

[12] Development Committee (2006). “Fiscal Policy for Growth and Development: An Interim Report”, prepared by Poverty Reduction and Economic Management, World Bank, April 6, p.i, Executive Summary. This report was attached to the April 23, 2006 Development Committee meeting.

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