The new IMF study on debt reduction: What it says, what it doesn’t

A recent study by three researchers at the IMF addresses an important question:  Under what circumstances should a country pay down its public debt? When countries face fiscal crises, they have no choice but to cut debt. When they need a Keynesian stimulus, they end up raising debt. But what about a country that is not at risk of a fiscal crisis and is near full employment – a country that is in what the researchers call “the green zone?” Should it pay down its debt (reduce its deficit) or pursue other objectives like public investment?

The IMF researchers write down a model that says that such a country should not pay down its debt; it should increase public investment financed by debt, instead. Public reaction to the study in the U.S. has fiscal doves exulting, but this reaction is misguided and it would be a mistake for policymakers in the U.S. to conclude that they can safely put aside worries about the huge U.S. government debt burden.

Two key issues have been misunderstood in the public discussion about the IMF research. First, the question of whether public investment should rise is distinct from the question of whether medium-term fiscal consolidation should occur. Second, the researchers’ results tell you about their own model, not necessarily about the real world, and their model makes two key assumptions that guarantee its results – that public infrastructure pays above the market rate of return, and that there are no benefits of debt reduction (if there is no prospect of fiscal crisis).

In fact, the right answer to the question about debt repayment – obvious to any careful observer – is “it depends.” One can easily imagine circumstances in the real world where the country should pay down its debt. For example, if the initial level of debt is too high, the costs of carrying debt are high, the opportunities for government to invest profitably or redistribute successfully are limited, and/or the costs of paying down debt are low. But the IMF researchers made different assumptions and so drew different conclusions.

The “special” nature of the IMF researchers’ results can be seen by noting the famous quote by Keynes that, “the boom, not the slump, is the right time for austerity.” The IMF researchers have set up a model where even the boom is a bad time to pay down debt (unless there is risk of a fiscal crisis). That conclusion, however, is obviously the result of particular assumptions they make – namely, that there are no benefits to debt reduction except in the case of a fiscal crisis – not a finding that applies in general to all real-world situations.

Some context helps understand the model and the implications for the real world. The researchers believe that some groups (we believe they mean in Germany and the U.K.) have come to see debt (or deficit) reduction as a goal that comes with very little risk and should be pursued regardless of circumstances. The researchers’ overarching point is that such reductions have both costs and benefits, and—given that they see the debate as currently biased toward over-emphasizing the benefits—they choose to emphasize the costs as a counterweight.

The manner in which the authors’ model understates the economic cost of high debt and understates the benefits of debt reduction is by assuming that people privately save in a way that strongly adjusts for and offsets public deficits (which represent negative government saving). This theoretical assumption, known to economists as “Ricardian Equivalence,” has been roundly rejected in empirical work. Ricardian Equivalence implies that government deficits do not reduce national saving and do not crowd out other investment, and hence deficit financing is very close to “free” for the economy. Moreover, paying down the debt does not help economic performance because with this model it would not crowd in new investment. This is why, in their model, debt is only a sunk cost and reducing it does not help the economy.

Evidence of this understatement of cost of debt is the authors’ estimate that a 50 percent-of-GDP increase in debt would reduce long-term GDP by only 2 percent.  Other studies suggest much larger costs. An earlier study by different IMF researchers finds that raising the debt-to-GDP ratio by 10 percentage points reduces an advanced economy’s annual growth rate over the next five years by 0.15 percentage points. Applying this estimate to a 50 percent of GDP increase in the debt, output growth rates would fall by 0.75 percentage points, implying that output would fall by almost 4 percent just within 5 years. The impairment to growth would accumulate into larger losses over the long-term. In a 1999 study, Douglas Elmendorf and Gregory Mankiw find that increasing debt by 50 percent of GDP would reduce long-term output by 4.75 percent. A 2013 Congressional Budget Office study finds that raising debt by 20 percent of GDP would reduce output by almost 2 percent after 10 years. A 50 percent of GDP increase would have a commensurately larger impact – about 5 percent of GDP.

In contrast to assuming there are no benefits of debt or deficit reduction, the IMF authors seem to overstate the benefits of public spending. They assume there are vast amounts of public investments available (equaling 40 percent of GDP or, in the United States, about $7 trillion) that pay more than (provide benefits that exceed) the market rate of interest (the marginal cost of funds used to pay for those investments). That is simply unrealistic, at least as far as the U.S. is concerned. And even if a sufficient number of such projects did exist, it is by no means clear that the political process would choose them as opposed to lower-return projects.

But the popular suggestion that the model presents a strong case against fiscal consolidation, by contrasting the (assumed) zero benefits of debt reduction against the (assumed) high net benefit of infrastructure spending, is misleading or at least beside the point. In the IMF authors’ model, even if there were not any valuable new public investments to be had, there would still be no reason to pay down the debt because there is assumed to be no benefit of doing so (assuming no risk of fiscal crisis).

Finally, the authors overstate the cost of raising revenues. They assume the only way to do so is by raising marginal income tax rates. But there are many other ways to raise revenue, such as through a value-added tax, a carbon tax, or by reductions in tax expenditures (distortionary subsidies delivered through the tax system) that would impose smaller economic burdens per extra dollar raised. And cutting forms of government spending that have little or no economic benefit relative to their cost—on the opposite end of the spectrum from what the authors assume about infrastructure spending—is another way to raise net public funds (reduce deficits) at low or negative marginal cost.

A few days after the IMF report was released, IMF Managing Director Christine Lagarde said, in an NPR interview, that:

The United States needs to have a medium-term fiscal policy that is aiming at reducing the long-term debt. In the immediate short-term, there is no great risk of increase of that U.S. debt. Then in the short-term, some measures can be taken in order to sustain growth, in order to encourage growth by way of infrastructure investment, for instance. We also believe that investment in education and job stimulation by way of vocational training, for instance, would be helpful. But we are linking the two together. Medium-term policies have to be identified, articulated and agreed. And if that is the case, short-term fiscal measures can be put in place to encourage and support growth, such as investment and infrastructure.

Lagarde’s position is not that fiscal consolidation should be traded off for more infrastructure and the associated short-term benefits; it is not an either-or decision. Lagarde is clearly saying that while additional public spending and investment should be undertaken based on its own merits, pursuing those shorter-term policy opportunities does not negate the need for dealing with the medium-and longer-term fiscal situation.

That position makes sense in the short term and in the long term; it addresses the economy’s needs now and in the future. In contrast, the public interpretation of the recent IMF study conflates fiscal consolidation issues and public capital issues and hence frames fiscal policy questions in a straightjacket that makes it impossible to discuss the issue clearly. In addition, the study makes assumptions about the benefit of debt reduction and infrastructure that literally guarantee their outcomes but are not particularly realistic.

Ultimately, the new IMF study generates the conclusion that if a country has public capital projects with benefits that exceed market returns and costs that equal market returns, it should make those investments. This is not a controversial idea. But it does not say anything that resolves the real-world debate about the appropriate timing and extent of debt reduction.