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Introduction

Perhaps the most frequent objection to a rules based approach to fiscal policy is the potential constraint this imposes on the discretion of the government to pursue macro-economic stabilization policy.

The debate between rules versus discretion in macro-economic policy has a long history in the economics literature (Merrifield and Poulson 2017). Ricardian equivalence suggests that private/public savings may offset the effects of a discretionary fiscal policy (Röhn 2010). The empirical literature supports the argument that savings offsets are larger in the long run than in the short run. However, estimates of the magnitude of savings offsets vary considerably in the different studies (Fall et al, 2015).

Recent research explores the relationship between debt and stabilization policy. Empirical studies reveal a nonlinear relationship between debt and discretionary fiscal policy. Nickel and Tudyke (2014) find that discretionary fiscal policy has a positive impact on output at moderate debt levels, but a negative impact when the debt-to-GDP ratio exceeds 65% to 70%. Rohn (2010) also finds that savings offsets to discretionary fiscal policy become stronger when the debt-to-GDP ratio exceeds 75%.

The Great Recession and slower economic growth in recent years have been accompanied by a discontinuous increased in debt/GDP ratios in most OECD countries, most notably the U.S. (OECD 2016). This debt burden has raised questions regarding the ability of these countries to pursue discretionary fiscal policy. This question has become more important as countries encountered the limits of accommodative monetary policy (Égert 2010; Brookings Institution. 2016).

Debt and Stabilization Policy in High Debtor Countries

There is now an extensive literature on the negative impact of debt on economic growth (Lo and Rogoff 2015). When countries accumulate debt that approaches the level of GDP, this debt acts as a drag on economic growth. The explanation for this negative impact includes both the direct effects of such borrowing on capital markets, and also the indirect effects on expectations.

The direct effects of public borrowing on capital markets is documented in these studies. Government borrowing is accompanied by rising interest rates that tends to crowd out private borrowing and investment. Private borrowing must generate a return that includes a risk premium, in excess of the riskless rate of return. When interest rates on government debt increase, some private investments that generate returns below that interest rate will be crowded out.

In high debtor countries, increased government borrowing has an additional negative impact on private borrowing and investment (IMF 2010; NBER 2011; OECD 2016). This is because public borrowing is at or close to the ‘debt limit’. ‘Debt limit’ does not refer to the legal limits that are imposed on public debt by statutory laws. Rather, ‘debt limit’ refers to the level of debt when the risk of insolvency generates explosive increases in interest rates that result in default on that debt. The expectation of default is likely to drive up interest rates on public debt well before that ‘debt limit’ is reached.

For high debtor countries the effect of debt on stabilization policy is influenced by interest rate changes. In the high debtor European countries interest rates have increased significantly in response to higher debt-to-GDP ratios. The higher interest rates offset the expansionary effects of discretionary fiscal policy (Turner and Spinelli 2013).

We can think of a danger zone in which additional borrowing pushes a country toward the debt limit. In this danger zone interest rates on public debt include a risk premium, as well as the riskless, or no default rate of interest. The danger zone for public debt is determined by investors’ confidence in the ability of a country to meet its obligations. These expectations are influenced by many factors, and can change rapidly, shifting the country toward the debt limit. Expectations can change rapidly in response to a speculative attack on a country’s currency, and in these circumstances the country is on the horns of a dilemma. If the government pursues a tight monetary policy, boosting interest rates to shore up the currency, this will have a negative impact on private investment and capital formation. If the government pursues an expansionary policy to hold interest rates low and promote private investment, devaluation could exacerbate a speculative attack on the currency.

Countries have an incentive to avoid this ‘danger zone’ in which economic instability is accompanied by a speculative attack on the currency. The most effective way to do that is to create fiscal space within which it can pursue countercyclical fiscal policy without triggering a speculative attack on the currency, or risk default on the debt. The debt ‘tolerance level’ is the level of debt below which a country has fiscal space to pursue countercyclical fiscal policy consistent with economic stability.

The ‘debt tolerance level’ as well as the debt limit are unique to each country, and reflect the counties experience with countercyclical fiscal policy (Merrifield and Poulson 2017). A country that has pursued prudent fiscal policies with low levels of debt is in an enviable position. The government has the fiscal space to can pursue a countercyclical fiscal policy, including discretionary fiscal policies, in response to economic shocks.

High debtor countries have debt levels that exceed their ‘debt tolerance level’. That means that they have little or no fiscal space to pursue countercyclical fiscal policies. The deficits and debt associated with discretionary fiscal policies can push them into the danger zone of capital market instability that leads to debt default. High levels of debt may even constrain the ability of a country to rely on automatic stabilizers, let alone discretionary fiscal policies, in response to economic shocks.

Many studies conclude countries with debt overhang are caught in a vicious cycle (Lo and Rogoff 2015). Debt overhang is accompanied by retardation and stagnation in economic growth; slower growth, in turn, makes it more difficult to reduce debt burdens. As credit markets perceive increased risk of default, the default risk requires higher interest rates, which makes it even harder to reduce debt burdens.

Some economists argue that the current low interest rates have expanded the fiscal space for countries to pursue expansionary fiscal policies, using long term bonds to lock in the interest rates (OECD 2016). Deficits in the medium term are justified as a stimulus to economic recovery, and to finance investments for long term economic growth. That view is challenged by economists who argue that high debt/GDP ratios have reduced, and in some cases eliminated, fiscal space; and that, at least for some countries, pursuit of expansionary fiscal policies exposes the country to the risk of default.

Fiscal Rules and Stabilization Policy

Fiscal rules may be designed to achieve a variety of objectives (Fall et al. 2015). The debate regarding rules versus discretion has focused on stabilization policy over the business cycle. Keynesians argue that the government should not be constrained by fiscal rules that would limit the reliance on discretionary countercyclical fiscal policies. But, the economic instability experienced in many OECD countries in recent years has led them to enact fiscal rules to reduce deficits and debt accumulation. These new fiscal rules may provide for countercyclical fiscal policy, but only within the parameters set by their fiscal rules.

In countries with high levels of debt, if the fiscal rules set a priority on reducing debt below the ‘debt tolerance level’, there is likely to be a tradeoff between this objective, and countercyclical fiscal policy. Reliance on Keynesian fiscal stimulus is likely to be constrained, if not precluded by the rules. A deficit financed boost in spending could push the country into the danger zone where it is exposed to higher interest rates, capital market volatility, and potentially default. Any positive impact of deficit financed increases in government spending on output are more than offset by the negative impact of loss of confidence and reduced investment and capital formation. Keynesian fiscal policies could expose the country to default risks that result in a sharp contraction in output.

However, fiscal rules in high debtor countries can be designed to provide for a different approach to countercyclical fiscal policy (Merrifield and Poulson 2017). Fiscal rules can focus on the automatic stabilizers; the automatic adjustments in taxes and spending that accompany the business cycle can be strengthened by fiscal rules.

The fiscal rules can provide for an emergency fund to stabilize spending in periods of recession. With strict rules requiring deposits into the emergency fund in periods of economic expansion, and disbursements from the fund to offset revenue shortfalls in periods of recession, the automatic stabilizers could stabilize budgets over the business cycle. If deficits are incurred in periods of recession, an amortization fund could require savings to offset that debt in the short term.

Economists who support a rules based fiscal policy have long advocated reliance on the automatic stabilizers as an alternative to discretionary fiscal policy. For high debtor countries the debt crisis may be a blessing in disguise; forcing them to enact fiscal rules mandating this prudent approach to fiscal policy.

Fiscal rules can also provide for a countercyclical capital investment fund. Savings are deposited into the investment fund in years when economic growth exceeds the long run average rate of economic growth. Withdrawals from the investment fund occur in years when economic growth is below the long run average. The capital investment fund would only finance infrastructure.  The benefits of counter-cyclical use of the investment fund arises from a more stable construction industry, and the counter-cyclical nature of investment bargains. Construction quality is down and price is up in the rapid growth phase of the business cycle (Finkel 1997).  Uncertain Keynesian macroeconomic benefits of counter-cyclical infrastructure spending (Fournier et al. 2015) would be on top of that.

In recent years many OECD countries responded to increased debt burdens by enacting fiscal rules designed to reduce debt/GDP ratios below tolerance levels (Fall et al. 2015). Among the most successful of these are European countries relying on national as well as supranational fiscal rules that require budget constraints whenever deficits and debt exceed tolerance levels. To the extent that these new fiscal rules are effective, this expands fiscal space, improving their capacity to pursue countercyclical fiscal policies. In that sense fiscal space cannot be separated from the fiscal rules in place constraining fiscal policy.

Debt and stabilization Policy in the U.S.

The fiscal rules now in place in the U.S. have failed to reduce and eliminate deficits, resulting in increasing debt –to- GDP ratios over the past half century (Merrifield and Poulson 2017). With total debt now in excess of GDP, the U.S. has emerged as one of the most indebted nations within the OECD. The levels of debt in the U.S. are now well above the tolerance level for debt. The U.S. is in the danger zone where external shocks would be accompanied by capital market instability. Another financial crisis could trigger a sharp increase in interest rates reflecting the growing risk of insolvency and default on the public debt.

The United States now exhibits all the symptoms of debt overhang and faces a major challenge in curing this problem. After seven years of recovery from the recent financial crisis, the country continues to experience rates of economic growth below the long term average. Rates of investment and capital formation, as well as productivity growth remain below the pre-crisis levels. In their long term forecasts, the CBO projects a continuation of slower rates of economic growth over the next two decades (Congressional Budget Office. 2016a, 2016b).

Debt overhang will limit the ability of the federal government to pursue a countercyclical fiscal policy. The countercyclical fiscal policies pursued in response to the recent financial crisis are no longer an option. Indeed, pursuit of a Keynesian fiscal stimulus, such s that pursued by the Obama Administration, is likely to exacerbate cyclical instability and reduce long run economic growth (Brookings Institution 2016; Committee for a Responsible Budget 2016).

To cure debt overhang, the United States must follow the precedent set by other Organization for Economic Co-operation and Development (OECD) countries, enacting effective fiscal rules to balance the budget and reduce the debt to a GDP ratio below tolerance levels (OECD 2016). The most effective fiscal rules require a cyclically balanced budget, and for spending to be limited whenever deficits and debt approach tolerance levels. Within the constraints imposed by these fiscal rules, the U.S. could create some fiscal space to pursue countercyclical fiscal policies. For the foreseeable future, countercyclical fiscal policies must focus on strengthening the automatic stabilizers. The fiscal rules could also provide for an Emergency fund and a Capital Investment Fund.

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Debt and Stabilization Policy

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