Optimal Public Debt in Europe
Massimo Rostagno, Javier J. Pérez García, Paul Hiebert, European Central Bank
Under a deficit limit there exists a trade-off between the government’s structural primary surplus and steady state debt ratios-to-GDP, and the admissible responsiveness of the surplus to the output gap. We exploit these basic identities to show how an optimum government debt-to-GDP ratio and an optimal degree of budget cyclicality can be jointly determined within a simple optimising model where households cannot borrow against future income and the deficit cannot exceed the 3% ceiling of Europe’s Stability and Growth Pact. In order to insure themselves against income shortfalls, households choose to partially pay down the inherited burden of debt. By so doing, they “purchase” (i) a cut in the non-contingent portion of the tax (i.e. the structural primary surplus) needed to sustain the debt indefinitely at its steady state ratio; and (ii) a permanently enhanced sensitivity of the tax to realised income conditions. Model-based calculations show steady state optimal debt ratios for a subset of EU countries clustered around zero.