When the next recession hits, how will fiscal stimulus affect government debt sustainability?

There’s a strain of thinking that argues any options for fighting the next recession are bound by the response to the past recession and other previous policy decisions. Take, for example, fiscal policy. Because the U.S. debt-to-Gross Domestic Product ratio rose from about 35 percent before the start of the past recession in late 2007 to roughly 75 percent in the first quarter of 2017, does this higher level of debt bind the hands of policymakers for the next time they might consider a fiscal stimulus program?

Not really, says a new research paper released last weekend at the Federal Reserve Bank of Kansas City’s Economic Policy Symposium, better known by the meeting’s location in Jackson Hole. Economists Alan J. Auerbach and Yuriy Gorodnichenko of the University of California, Berkeley look at how higher government debt burdens might make future government stimulus programs quite costly. In other words, they investigate how much of an impact a stimulus program would have on being able to spend money in the future while servicing existing government debt.

Unlike many other studies of this question, these two economists don’t try to parse out the exact steps through which government spending would affect the sustainability of government debt. Instead, using a dataset covering 20 major countries that are members of the Organisation for Economic Co-operation and Development over a number of years from the 1980s to 2017, they measure how much an economic shock in the past changes the movement of a variable over time—in this case, interest rates and debt-to-GDP ratios, among others. The two economists find little evidence that short- and long-term interest rates increase after a fiscal shock, and that debt-to-GDP ratios don’t change that much either.

But there’s another important finding. Auerbach and Gorodnichenko note that these results differ depending upon when the fiscal stimulus happens. If the shock occurs when an economy is already in recession, then the effects are still quite muted. But if spending is increased when the economy is near full potential, then the increase in interest rates and debt-to-GDP ratio will be larger. How much these measures of sustainability would react to a stimulus plan today depends on how far U.S. GDP is from its potential.

Any successful future fiscal stimulus efforts may well depend on whether a high debt-to-GDP ratio will influence or impact the sustainability of future government borrowing. Auerbach and Gorodnichenko find that the cost of borrowing goes up slightly more when initial debt loads are higher, but the difference isn’t all that much. It seems unlikely that in the face of a recession even countries with high debt-to-GDP ratios would see large increases in the cost of borrowing if they spend to stimulate the economy. 

Policymakers who view the current debt-to-GDP ratio with trepidation, fearing that any attempt to increase spending during the next recession would result in unsustainable government debt levels, should take heart. As Equitablog’s own Brad DeLong and former U.S. Treasury Secretary Lawrence H. Summers have argued, strong government stimulus during a downturn might actually pay for itself. Fears of “bond vigilantes,” who would ostensibly flee U.S. government debt in the wake of a new stimulus program, are overblown. If anything, the fear should be that the government doesn’t spend enough to generate a strong recovery.