The value of sovereign debt

While in the blogosphere economists argue on the level of fiscal multipliers, whether or not debt is a burden on future generations, and why governments should cut or increase spending (see also here), the discussion ignores a fundamental and interesting question. Why does government debt exist at all? Would sovereign debt arise in a world ruled by benign and rational politicians?

In addressing this question, it is useful to start from a perfect world. In this world, consumers anticipate that the government will have to raise taxes in the future to pay off its debts. Therefore once a government issues debt, consumers will start saving to pay for that future tax increase. Consequently, an increase in government debt has no impact on consumption (the infamous Ricardian equivalence). By issuing debt instead of raising taxes the government merely reallocates consumption. Now if markets work perfectly, reallocating consumption will distort efficient prices and can only reduce welfare. Thus, in this ‘perfect’ world, sovereign debt is useless or even harmful.

Of course, the world is not perfect and government debt might have value because of the presence of imperfections, such as incomplete contracts or asymmetric information. I discuss five reasons related to these imperfections below.

But first a caveat. The complexity of a topic can be judged by the amount of issues one has to ignore before getting straight answers. By that standard, sovereign debt is a complex topic. What happens if the government is subject moral hazard, short-termism and other imperfections? Why do creditors believe that governments will repay their debt at all?  What should the appropriate intergenerational discount rate be? All these are worthy questions that deserve deep discussion – but not in this post.

Reason one – smoothing ups and downs in economic circumstances (insurance)

The most commonly mentioned reason for sovereign debt is that countries use debt to absorb shocks. When a banking crisis hits, governments respond by rescuing the financial system. When the economy tanks, government expenditure increases while tax receipt decrease. Accommodating these shocks entirely through changing tax rates or shrinking government expenses may be costly. Accumulating debt may be an alternative way to accommodate such shocks. Note that such an insurance mechanism may be more valuable when other mechanisms, such as a flexible exchange rate, are absent.

Reason two – meeting a demand for liquid assets

Another reason may be the government debt responds to a demand for liquid assets. Very safe assets allow firms or banks to temporarily park their cash and can function as collateral. It is akin to a form of money. Thus, there might be a natural demand for such assets and if the level of sovereign debt is very low, then the price investors are will to pay for these kind of financial assets is very high. This makes issuing debt an attractive way for governments to finance their expenditures.

Reason three – financing profitable investments for financially constrained generations

A current generation may face a situation where a lot of socially desirable investment opportunities are present, but there is simply too little cash to pay for these. Debt is then a way to shift income from future generations to current generations. Of course, a benevolent government only does so if they think future generations will face circumstances with less valuable investments.

Reason four – distributing the costs of investments between current and future beneficiaries of investments

Future generations may also benefit from current investments in for example infrastructure, human capital, or the quality of institutions. Consequently, it is efficient that part of the burden of making these investments falls on future generations.

Reason five – as a device for politicians to commit to good conduct by exposing themselves to market discipline

Another reason may be that sovereign debt introduces market discipline. The price of sovereign debt may create a market signal. A high price then signals that the government is not conducting good economic policy. In addition, because voters often hold a considerable fraction of their sovereign’s debt, politicians commit themselves to prudent government by issuing debt.

What do we learn from this? Well, although debt ceilings undoubtedly have benefits, if debt and changes in debt levels have an economic function then setting such ceilings too low may also have costs. And these costs may be particularly high when it truncates the already limited ability of governments in a monetary union to insure their population against economic shocks.

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