Abstract

Public Debt Arithmetic: Two Unpleasant Examples

If real interest rates remain above real growth rates of output in the long run, the current fiscal policy stance in many countries will become unsustainable. The required policies for handling this situation face the following dilemma: Primary deficits (= deficits excluding interest payments) must be adjusted to preclude an explosive development of the debt-income ratio. The more rapid this adjustment is executed, the lower will be the necessary primary budget surplus that guarantees sustainability of the debt-income ratio in the long run. But rapid adjustment will imply high short-run costs in terms of output and employment losses. Slow adjustment implies, however, that the long-run surplus has to be higher than in the case of rapid adjustment. Moreover, a slow adjustment strategy might entail other costs as well, if, e.g. real interest rates increase in response to the expected higher future debt-income ratios. This paper discusses two models intended to illustrate the dilemma. In the first model, we assume an exogenous maximum for the primary budget surplus sustainable in the long run. This model is suited to illustrate the relationship between the speed of adjusting the deficit, the solvency of the sovereign and the sustainable long run budget surplus. The second model introduces a “vicious circle” element into the model by linking the real interest rate to future budget deficits. One implication of the second model is that the long run sustainable debt-income ratio is bounded from above without introducing an exogenous upper bound for deficits as in the first model.