On debt sustainability, functional finance, and the transfer problem

Here are some notes on public debt sustainability. Since WordPress apparently cannot tolerate equations I am forced to post the pdf version here and the introduction and main themes below: On debt sustainability

Anyone invested in Argentina right now will benefit from reading till the end.

More generally, feel free to dip in. Comments welcome.


HOW OUGHT sustainability of public debt be assessed? And how should this assessment inform public taxation and spending decisions now and in future?

There are few questions of greater import in macroeconomics today. Yet answers remain elusive; often, discussions of fiscal policy are anchored by the need to attain a 60 percent debt-to-GDP ratio—or, more simply, the notion that public debt is too high. But why? What grounds are there for any debt target?

More worrying, perhaps, is the fact the international community struggles to understand lessons from the past decade. What is the correct stock of public debt? Why exactly was it necessary for Greece to default, but not Portugal? Is Argentina’s public debt today sustainable? We’ll get these questions.

Yet upon the opportunity to rethink debt sustainability analysis (DSA) in 2011, IMF staff acknowledged previous analysis “often turned into a routine exercise, with mechanical implementation of the DSA template, little discussion of DSA results, and limited linkages between the DSA and discussion of macroeconomic and financial policies” (¶2). At this crucial opportunity to fundamentally challenge and rethink sustainability—including key metrics such as the 60% debt-to-GDP target, the meaning of fiscal space, and the link between fiscal and external sustainability—the Fund doubled down on the pre-existing framework. We are stuck in the same old grooves of pre-crisis thinking.

That the framing of public debt and fiscal policy has barely moved on from a decade ago is a matter of huge concern. Absent policy tools following any near-future macroeconomic malaise, we ought carefully reassess our thinking. It is crucial we do not succumb to irrational fear of public debt; we need to sustain the flow of aggregate spending in the years ahead. We ought also educate the public against the false notion that public debt is always a burden—in fact, it can be a public good.

Unfortunately, economics lacks fresh thinking—groping in understanding, deflationary in mindset, atavistic in morality-of-debt thinking.

Fortunately, a conference in Washington, DC tomorrow offers an opportunity to set the record straight. Let’s pre-empt therefore five messages on public debt that ought emerge from this conference.

First, public debt need never be repaid.

Second, a 60% debt-to-GDP target is unnecessary, and for the public misleading.

Third, public debt reflects private savings.

Fourth, the complete, consolidated state balance sheet matters.

Fifth, sometimes the balance of payments matters most.


4 thoughts on “On debt sustainability, functional finance, and the transfer problem”

  1. Hello,
    can you elaborate further on why public debt will never be repaid?
    A friend of my is banker and he told me something similar, that “(Japanese) government debt will never be repaid, it will be rolled over.”


  2. Hello,

    can you further elaborate and the term “public debt is never going to be repaid”
    Is that because highly indebted economies, like Italy or Japan, don’t have the fascial position now and in the further to pay of that huge amount of debt?

    Thank you


    1. There are several ways to answer that question. One is to observe a long series of public debt for an economy. Take the U.K. where debt figures are available, published by the Bank of England, for a couple of centuries (from memory.) Look at the stock of debt at face value (not divided by GDP) and there are very few occasions where debt decreases over time; if you plot the time series you won’t be able to see it. It falls in percent of GDP on occasion, but virtually never in absolute terms. But why?

      Public debt might alternatively be called private assets, because by definition it is some claim on the government by the private sector, some deferred consumption, that has been provided. So the government gets to spend and someone in the private sector gets to have some wealth. So the circumstances when public debt might need to be “repaid” would be if the private sector decided they no longer want to hold wealth but instead choose to spend it. Now imagine what would happen if the private sector as a whole decides not to save through government debt but to spend it on investment or consumption today. What would happen? Would the government be forced to repay at least part of the debt? Actually, under lost normal circumstances, the debt would fix itself. The act of spending by those holding the debt would raise activity of the private sector, automatically raising tax receipts which the government can use to run off some of the debt, or the pressure on inflation would encourage a tightening of monetary conditions and a rise of bond yields such that others will choose to save, offsetting some of the spending impulse imparted by those trying to spend their accumulated claims on government debt.

      In other words, the economy does much of the adjusting for the government; providing there is no effort to offset the tightening of monetary conditions those need not end in destructive inflation and the disorganisation of activity, but a reshuffling of claims on the government from one set of creditors to another.

      Alternatively, what are the means by which the community as a whole can transfer wealth between generations? Historically, land would be the physical asset that best served to facilitate bequests. But there is only a finite supply of land, and to transfer wealth the private sector needs an “outside asset” that they can use for that purpose. Government debt provides such an asset, since the government is perpetually lived even if households are finite. So the government provides a link between generations that few other vehicles can achieve. It can be held directly as claims on the government or indirectly as money claims on the banking system which holds the claim on government for society. When people complain about the size of government debt, they probably don’t realize it is their savings they are talking into non existence. If government debt is to be eliminated, those savings will also have to be destroyed.

      In Italy and Japan, two ageing societies, it is not a weakness that debt is high, but a consequence of a community in its dotage preparing to pass on the fruits of a lifetime of labour through to the younger cohort through the vehicle of government debt.

      There are circumstances when government debt can be too high. But that’s usually because it is help by nonresidents and requires foreign exchange to service, so foreign debt requires trade balance surpluses to service. If a country hasn’t got the productive base to generate resources that can be sold abroad to service external debt, then it becomes a problem. Italy’s debt was a problem when combined with a current account deficit in the 2000s, hence the euroarea crisis. Once she attained a current account surplus, so were able to service the debt, the crisis had passed. Japan has not run a current account deficit in living memory, and nonresident claims on Japan are minimal, so the debt there has never been a concern.


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