Public Debt
Redistributive effects

There is now a rich literature on intergenerational redistribution schemes such as social security taxes and retirement benefits which provide insurance that the market either cannot provide or provides inefficiently. In Discussion Paper No. 680, Research Fellow Willem Buiter and Kenneth Kletzer use an overlapping generations model to examine the government's ability to expand or alter the set of possible equilibria by issuing or retiring debt. They define a government to be `solvent' if it satisfies certain inequality constraints on admissible sequences of taxes, transfers, public debt and exhaustive public spending, derived from the requirement that the capital stock and private consumption can never be negative.

Whether the government's ability to issue debt is useful depends critically on its set of available lump-sum, tax-transfer instruments. For an economy whose long-run real interest rate exceeds its `real growth' rate (the sum of long-run growth rates of the labour force and labour productivity), with fairly tight restrictions on the use of taxes and transfers, this is equivalent to the `conventional' solvency constraint: that the sequence of real public debt, discounted at the real interest rate to a fixed date, converges to zero. Under less restrictive conditions, `Ponzi finance' may be possible, i.e. the growth of the public debt may equal or exceed interest payments on outstanding debt in all periods. With unrestricted taxes and transfers, Ponzi finance is possible, regardless of the relationship between the long-run real interest and growth rates.

Buiter and Kletzer distinguish between `essential' Ponzi finance, which expands the possible set of equilibria for consumption and capital formation, and `inessential' Ponzi finance, which has no real effects. With no restrictions on time- and age-specific taxes and transfers, the ability to depart from budget balance permits no additional equilibria. With restrictions on the government's ability to levy and make age-specific taxes and transfers, Ponzi finance expands the set of possible equilibria, provided the authors' `less restrictive' solvency constraint applies. But even quite severe restrictions on the variation of taxes and transfers over the lifetime of a generation do not restrict the set of possible equilibria with unbalanced budgets; this result holds under either solvency constraint but does not require Ponzi finance.

Buiter and Kletzer conclude that a sufficiently rich tax-transfer menu will enable a government to achieve any desired intergenerational redistribution and insurance with public debt, without it or indeed with public credit. It is constraints on tax-transfer options that make public borrowing or lending valuable for intergenerational redistribution or insurance.

Government Solvency, Ponzi Finance and the Redundancy and Usefulness of Public Debt
Willem H Buiter and Kenneth M Kletzer

Discussion Paper No. 680, August 1992 (IM)