Fiscal sustainability post COVID-19

The danger of high debts post COVID-19

In this policy brief Daniel Gross argues that there are quite a few reasons that the post COVID-19 high government debt might not be sustainable even if interest rates continue to be low. The reasons are:

• First and foremost there is high uncertainty about future growth prospects;
• Large negative shocks are more frequent than they are assumed in standard models;
• The convex nature of the cost of public debt which implies that the cost of doubling the debt/GDP ratio is much higher than just doubling the interest service, because the higher taxes needed to service this debt create more and more distortions.

High Public Debt in an Uncertain World: Post-Covid-19 Dangers for Public Finance
By: Daniel Gross – CEPS

A “free lunch” theory of government debt

No, this is not MMT as Mian et al. propose a model that identifies the exact conditions under which a free lunch policy works or does not work. The authors propose a tractable model of fiscal policy that encapsulates the trade-off between the need to run persistent fiscal deficits in order to stimulate demand and the future risk of unsustainable debt if deficits are not reduced.

A crucial property of the deficit-debt locus is that it is hump-shaped when the demand for government debt is sufficiently high: without debt, there is no steady-state deficit or surplus, and with large levels of debt, R rises above G, requiring a surplus. With intermediate levels of debt, R < G and the government can run an indefinite deficit. The maximum of the deficit-debt locus is the largest permanently stable deficit a government can run. To the left of the maximum, we show that the government has access to a “free lunch”: it can permanently raise the deficit, without ever having to raise taxes.[…] The framework suggests that governments can try to live off permanent deficits, but this is potentially dangerous when deficits are used to address longer-run structural problems such as rising inequality and an aging population.

Their empirical calibration for Japan, Italy, Germany and the U.S. shows that Italy has much less fiscal space since it does not borrow in its own currency and aggressive Italian fiscal policy cannot sustainably increase Italian inflation. Germany, on the other hand, despite being part of a monetary union, has more fiscal space since its real growth rate exceeds that of Italy’s.

A Goldilocks Theory of Fiscal Policy
Authors: Atif Mian, Ludwig Straub, Amir Sufi
From: Princeton University, Harvard University, University of Chicago