Public debt: A double-edged sword

Government borrowing (debt) is essential for economies to grow, and while New Zealand’s debt-to-GDP level is nothing to worry about, care is still needed, writes economist Dennis Wesselbaum.

Fiscal policy – how much and what the Government spends money on and how it finances its expenditures – is the most directly related part of macroeconomics with politics. The reason for this is that redistribution (over time, over generations, and across individuals) is at the core of our political debate. Even providing public goods (roads, schools, parks, etc) is progressive, as the usage of these likely varies by income. NZ had two recent episodes where the Government substantially increased public debt via increased spending: the Canterbury Earthquakes and the Covid-19 pandemic. According to OECD data for 2019, general NZ government debt as a fraction of GDP stands at 55% (OECD average is 95%).

Why do we need debt?

Debt (private and public) is essential for economies to grow, and it reduces macroeconomic volatility. Further, it provides liquidity to households and firms, which can reduce credit constraint and increase investment. It is therefore important for the short- and the long-run wellbeing of the economy. Public debt is important as it allows smooth consumption over time and generations, and to finance lumpy investment. Because future generations will be better off (due to more human capital and higher productivity), transferring from future generations to the current one can increase welfare. Some of the required tax increase to fund this debt is postponed and, hence, government debt increases. This does not necessarily imply that economic growth will slow or that inflation will occur. However, accumulating debt is not free of risks and can have adverse macroeconomic consequences. Excessive borrowing by governments can limit the ability to provide services to citizens and could result in a financial crisis and, ultimately, default with associated negative macroeconomic consequences.

Reasons for excessive debt accumulation

Looking into historical data, we see many countries have what we call “excessive” debt-to-GDP ratios. French economist Charles Wyplosz showed that in a sample of 20 OECD countries, only four had a deficit for less than 50% of the time since 1960. Italy and Portugal always had a deficit over this period. If macroeconomic research informs the “optimal” level of government debt, why do we see debt beyond this optimal level in many countries and in a persistent way? Various reasons have been discussed in the literature, but I only want to highlight two. First, voters could suffer from “fiscal illusion”. That is, they do not understand the budget constraints faced by governments and overestimate the benefits of spending relative to the costs due to future taxation. Further, while governments pursue “Keynesian” policies, that is spending in a recession and generating deficits, they fail to cut spending and realise surpluses during an expansion. This leads to excessive debt accumulation. A related reason that does not rely on the assumption of voters being irrational or inattentive is the theory of political budget cycles.

These models often assume imperfect information. Governments can invest either into “visible” policies, e.g. fixing holes in streets, or “invisible” policies, e.g. increasing the quality of teachers. Governments have an incentive to overspend on visible but less-useful policies before an election.

Why does debt hurt economic growth?

Negative effects of debt for growth emerge for various theoretical reasons: higher long-term interest rates, higher future distortionary taxation, higher inflation, and higher uncertainty. If debt does reduce economic growth, this will also exacerbate the effects, as lower GDP will automatically increase the debt-to-GDP ratio. Research has shown debt surges come before banking crises. Banking crises precede or accompany sovereign debt crises. Higher debt levels also imply a larger degree of vulnerability to unforeseen events. Even for small shocks, leveraged borrowers might no longer be considered creditworthy by the market, which might reduce lending to these countries (or at least increase spreads). This will lead to lower consumption and investment. If the recession is sufficiently large, this could also lead to defaults further reducing economic activity. The more debt is held, the larger this effect would be, implying larger volatility of the economy. Debt could therefore lead to disruptive financial cycles, in which expansions are fuelled by credit and recessions are driven by defaults.

An important aspect here is market confidence. Research refers to “debt intolerance”. Market interest rates (on government bonds) respond in a non-linear way as countries get close to the debt tolerance limits. These spikes in interest rates either cause fiscal adjustments (e.g. Greece) or default (e.g. Argentina). This non-linear effect could explain why debt has a non-linear effect on economic growth.

Overall, excessive debt levels can, therefore, reduce capital accumulation, productivity and, ultimately, economic growth. These theoretical reasons suggest there is an “optimal” debt level beyond which debt has negative effects. The question is: what is the optimal level? Does it exist in the real world?

Does debt hurt economic growth?

In an influential paper by Carmen Reinhart and Kenneth Rogoff, “Growth in a Time of Debt”, the authors show that beyond a debt-to-GDP ratio of 90%, economic growth will be negatively affected, but that inflation is not affected by additional debt.

The literature has since then found different optimal levels of debt (e.g. 66%, 77%, 85%) and studies even found no significant effect at all. To me, the studies finding no relationship are most plausible (for technical reasons, which I do not want to discuss here).

When is debt stable?

A related issue when we discuss government debt is whether the debt level is sustainable. An unsustainable debt path would be where debt (or the debt-to-GDP ratio) “explodes” over time, i.e. it becomes larger and larger rather than reaching a limit. Intuitively, sustainability depends on whether the Government will be able to repay its debt. Here, one can show that if the economy grows faster than interest rates, debt is on a sustainable path.

Maturity and foreign debt

A crucial issue I have not discussed is the maturity of debt. Research has shown that countries relying excessively on short-term borrowing are vulnerable to crises in confidence. These can result in sudden financial crises. Long-term debt is beneficial, because it allows the country to insure against fluctuations in interest rate spreads, while short-term debt creates stronger incentives to repay debt and to be fiscally responsible.

I have also assumed that debt is held entirely domestically. If debt is held denominated in a foreign currency, it reduces the chance that the Government inflates away debt, but it makes the country vulnerable to exchange rate fluctuations.

Some final thoughts

Should we be concerned about NZ’s debt-to-GDP ratio? No.

There is no robust evidence that says there is a point beyond which debt would hurt the economy. Even if the values found in the literature were robust, we would be far away from them. This does not mean, however, that we should keep spending.

We should spend on anything that makes us more productive in the future (e.g. education, infrastructure, and health) but reduce unnecessary or wasteful spending. Further, the Government needs to always keep fiscal space in case another major disaster hits the country.

• Dr Dennis Wesselbaum is a senior lecturer at the University of Otago, Department of Economics.