Average net public debt rose as a percentage of total output for the G7 countries from slightly under 20% in 1970-4 to slightly over 30% in 1985-9. This does not just reflect the well-known US fiscal deficit: the Japanese and West German public sectors which were net creditors in 1970-4 have become significant debtors; in France the share of net public debt in GDP has almost tripled since the early 1970s; Canada's public debt/GNP ratio has quadrupled; and Italy remains in an unsustainable spiral of deficit and debt. Only in the UK, following the IMF's 1976 stabilization programme and the Conservatives' Medium Term Financial Strategy of the 1980s, has public debt fallen significantly. This rise in debt/output ratios appears to have stopped recently (except in Italy), aided no doubt by fiscal consolidation and the progress of the business cycle, and the net public debt/GDP ratios of the main industrial economies are expected to remain stable for the foreseeable future.

In Discussion Paper No. 490, Research Fellow George Alogoskoufis uses an equilibrium growth model, in which households choose their optimal savings levels, to study the long-run implications of the general rise in steady-state public debt ratios and of their variation across countries.

Alogoskoufis demonstrates that a generalized rise in public debt financed by tax increases leads to higher world real interest rates and lower capital stocks and hence lower equilibrium real wages, output and private consumption than the same rise financed by reductions in government consumption. A relative rise in one country's public debt leads to a reduction in its net foreign assets, which will be greater if financed by higher taxes leading to a fall in its relative consumption rather than by government consumption cuts. A generalized increase in public debt ratios financed by monetary growth has no effect on world real interest rates, capital accumulation or consumption, but it affects both inflation and real money balances. On the other hand, monetary financing of a relative increase in public debt ratios has no effect on relative consumption or external debt, but it does affect relative inflation and money demands and nominal exchange rates.

The results suggest that cuts in government consumption will lead to higher productivity and higher private consumption than equivalent tax increases. Further, countries with high relative public debt ratios may find themselves with higher external debt and lower private consumption if they peg their exchange rates to those of `low public debt' countries than if they adopt independent monetary policies and partly monetize their higher debts.

On Public Debt Stabilizations in an Interdependent World
George S Alogoskoufis