That Squeezing Feeling: The Interest Burden and Public Debt Stabilization

• Author: Tidiane Kinda,Xavier Debrun
• DOI: http://doi.org/10.1111/infi.12090
• Published date: 01 June 2016
• Date: 01 June 2016

That Squeezing Feeling: The

Interest Burden and Public

Debt Stabilization

Xavier Debrun and Tidiane Kinda

International Monetary Fund.

Abstract

The paper explores the extent to which the pressure of debt service on

other spending items may magnify governments’concern for debt dynam-

ics, independently of the public debt level itself. Our empirical analysis

identifies thresholds of interest bill indicators beyond which governments

appear to intensify efforts to curb the debt trajectory. Hence, in the

current context of historically high public debts, a country experiencing

high and rising borrowing costs and interest payments would be more

likely to enact a more aggressive fiscal consolidation than one benefitting

from persistently low interest rates –even though both consolidation

paths would be consistent with solvency. This could be an important

consideration when setting the appropriate pace of normalization of

monetary policy.

The views expressed in this pap er are those of the authors and do not necessarily represent thos e of

the IMF or IMF po licy. Without implicating them in remainin g errors or omissions, comments by

Carlo Cottarelli, Mart ine Guerguil and semina r participants at the European Central Bank Pu blic

Finance Workshop as well as at the IMF a nd CERDI (Universit

ed’Auvergne-Clermont 1) led to

substantial improvements in the paper. We are also most grateful to two anonymous referees for

suggestions that led to consi derable improvements to the paper.

International Finance 19:2, 2016: pp. 147–178

DOI: 10.1111/infi.12090

© 2016 John Wiley & Sons Ltd

‘I am doing this because each yearFrance pays 49 billion euros as interest on its debt.’

Nicolas Sa rkozy, French Presid ent (2007–12) announcing a n austerity package in 2011,

when the interest bill became, for the first time, the budget’s largest spending item.

I. Introduction

For most advanced economies, high public debt will remain a lasting legacy of the

global economic and financial crisis of 2008–09. Confronted with a sluggish recovery

and persistent headwinds, many governments face the challenging task of dealing

credibly with the need for large fiscal adjustment, while avoiding excessive fiscal

retrenchments that could derail growth. Like all aspects of fiscal policy, however,

governments view that trade-off in light of objectives other than just stabilizing short-

term growth, including the provision of a stable stream of public goods and services

over time. These objectives motivate the quote reported above: debt service diverts

taxpayers’money from items governments consider useful, and because any new debt

issued to fund presentprimary spending ultimately curtails future fiscal space,there is a

limit to the annual debt burden a politician is willing to tolerate. This argument goes

beyond the mereavoidance of continuously paying interestwith new borrowing (the no-

Ponzi condition) or the need to remain solvent; it reflects a conscious choice to secure

the provision of public goods and services now and in the future.

A simple theoretical illustration helps clarify the reasoning. Under the rather

weak assumption that de bt service outl ays do not directly generate social utility

(and implicitly, that taxes are distor tionary), th e optimal fiscal policy path depends

on current and future costs of servicing the debt (inherited and new). Specifically, if

the bulk of service cos ts falls on future period s, as is generally t he case, a higher

inherited debt level i ncreases the optim al primary bala nce in the current period to

make space for future outlays on items governments cons ider useful. The ar gument

does not presume any binding constr aint on the borrowing capacity (in whi ch case

the government would obviously have to cut present pri mary spending or ra ise

revenues to service the d ebt), nor does it assume away the governm ent’s capacity or

willingnes s to face its financial obligations in full. Thus, the effect of debt service on

optimal polic y is not a mechanical result of the solvency const raint.

1

The aim of this paper is to explore empirically the extent towhich high and rising

debt service af fects governments’concerns for debt dynami cs. To do so, we augment

the regression-based solvency test proposed by Bohn (1998) with in dicators of

the pressure that interest payments exer t on fiscal space. Estimates a re performed

using a large panel of 29 advanced and 27 emerging economies from 1980 to

2010. The analysis also formally explores whether polic y makers’response to the

1

Formally, the argument emanates from an i nterior solution.

148 Xavier Debrun and Tidiane Kinda

© 2016 John Wiley & Sons Ltd

interest-payment squeez e is smooth or whethe r it is subject to non-li nearities or

threshold effects.

Our findings generally suggest that all else equal, a larger interest bill strengthens

governments’response to public debt dy namics. The firs t implication is th at periods

of persistently low interest rates, despite rising debt stocks, could encourage

complacency in t he face of al ready very hig h public debt l evels. Unconventional

monetary policy could thus weaken the credibilit y of official commitm ents to bring

down public debts unless they are backed by strong institutional frameworks such

as effective fisca l rules. The second impl ication is that in the context of h igh

inherited debt , the breach of poli tically sensit ive thresholds for interest pay ments

could encourage polic y makers to opt for a more aggressive pace of consoli dation

than is currently the c ase. This could be an i mportant consideration for centra l

banks when settin g the pace for the eventual nor malization of moneta ry polic y.

Third and finally, the fact that, for a given debt level, r ising interest payments se em

to intensify fisca l consolidation mit igates the conventional interpretat ion of rising

debt service as a n indicator of a greater risk of default or debt restruct uring.

The rest of the paper is orga nized as follows. Sect ion II illustrates the b asic

economics of the relati onship between debt s ervice and opt imal fiscal policy. Section

III describes the empi rical approach and presents some si mple correlations betwe en

public debt and various in dicators of interest payments. Sec tion IV discusse s the

results and their robust ness. The fifth and last sect ion concludes.

II. High Debt Legacy, the Rate of Interest and Optimal

Fiscal Policy

To understand the basic relationship betwe en inherited debt le vels, the interest rate

and optimal fiscal policy, consider the simplest possible two-period deterministic

model of fiscal policy, featuring a utility function and budget identities.

2

Tot a l u t i l i t y

Uis separable over ti me (the two periods are in dexed by 1 and 2):

U¼uq

1



þ1

1þduq

2



;ð1Þ

with d, the subjective discount rate of the government, and q

i

(i¼1, 2), the quantity of

public goods and services delivered in period i. The period utility functions are twice-

continuously differentiable with the conventional properties: u0>0andu00 <0.

At the beginning of the first period, the governme nt is hit by an exogenous shock

on public debt –for examp le, implicit or cont ingent liabilit ies materializ e –leaving

initial debt level b

0

. Taking as given a proportional tax rate (t) on a predeterm ined

2

See, for instance, Tabellini and Alesi na (1990).

© 2016 John Wiley & Sons Ltd

The Interest Burden and Public Debt Stabilization 149