Academic journal article International Advances in Economic Research

Public Debt Reduction in Advanced Countries and Its Impact on Emerging Countries

Academic journal article International Advances in Economic Research

Public Debt Reduction in Advanced Countries and Its Impact on Emerging Countries

Article excerpt

Published online: 6 April 2013

[C] International Atlantic Economic Society 2013.

Abstract Financial crises accompanied by banking crises often entail heavy fiscal legacies. For the U.S., for example, the gross government debt to GDP ratio exceeded 100 % in 2012. Due to the unsustainability of public debt, both in the U.S. and in other advanced countries, moves towards a substantial reduction in debt levels would appear to be unavoidable. However, as shown in this paper, the long-run welfare impact of debt reduction in advanced countries, both at home and abroad, may prove to be somewhat of a disincentive for policy makers. In particular, we find that under conditions of dynamic inefficiency, and when Home (U.S.) has a negative external balance and a lower capital production share than Foreign (China), both domestic and foreign welfare decrease if Home reduces public debt.

Keywords External balance * Capital production share * Public debt Real exchange rate * Two-country OLG model * Welfare

JEL F41 * H63

Introduction

The loss of tax revenues in the Great Recession of 2009, together with the subsequent expansionary fiscal policy, have led to high public deficits in many developed countries. For the U.S., e.g., an increase in the gross government debt to GDP ratio of more than 100% is predicted for 2012 (OECD 2011), and the figure 1 is expected to rise for several years to come. The situation is even worse in Europe, where some countries are close to achieving their maximum sustainable levels of public debt. Due to the unsustainability of public debt both in the U.S. and in other advanced countries, moves towards a substantial reduction in debt levels would appear to be unavoidable. However, as shown in this paper, the long run welfare effects of debt reduction in advanced countries, both at home and in emerging countries, may be somewhat of a disincentive for advanced countries' governments.

In contrast to the 1980s, when the spill-over effects of unprecedented levels of U.S. budget deficits under the Reagan administration on countries with a similar production technology and similar savings rates (i.e., European economies) were a cause for concern (Feldstein 1986), internationally interdependent countries today are characterized by significant technological differences and by diverging savings rates (i.e., advanced and emerging countries). For example, Bai and Qian (2010) reported a nearly 50% production share of capital in China, while according to Caselli and Feyrer (2007), the corresponding U.S. share is below 30%. (1) Ma and Yi (2011) reported that the savings rate of China in 2008 was 54% compared to 26% for Germany and 12% for the U.S.

Moreover, while in the late 1980s the world economy entered a phase of dynamic efficiency (i.e., the world real interest rate was larger than the world GDP growth rate), in the first decade of the 21st century, before the outburst of the financial crisis, the world economy was more or less in accordance with the Golden Rule (the GDP growth rate is equal to the real interest rate). Since then, dynamic inefficiency (the GDP growth rate is larger than the real interest rate) has prevailed (IMF 2011, 212). Another characteristic of the world economy over the past two decades has been the huge external imbalances (net foreign asset positions) among major economic areas: the United States has become a large net foreign debtor, and China. Japan, and oil-exporting countries are now net foreign creditors to the world economy (IMF 2006, 74; IMF 2008, 35).

The aim of the present paper is to show how country differences in capital production shares, savings rates, and dynamic (in)efficiency matter with respect to the economic (private capital accumulation, real exchange rate) and welfare effects of unilateral debt reduction. We use a two-good overlapping generations (OLG) model with two countries interconnected through trade in commodities and government bonds. …

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