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Fiscal sustainability using growth-maximizing debt targets

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Abstract:

This article highlights the importance of debt-related fiscal rules and derives growth-maximizing public debt ratios from a simple theoretical model. On the basis of evidence on the productivity of public capital, we estimate public debt targets that governments should maintain if they wish to maximize growth for panels of OECD, EU and euro area countries. These are not arbitrary numbers, but are founded on long-run optimizing behaviour assuming that governments implement the golden rule of financing; that is, they contract debt only to finance public investment. Our estimates suggest that the euro area should target debt levels of around 50% of GDP if member states are to have common targets. That is about 15% points lower than the estimate for the growth-maximizing debt ratio in our OECD sample and comfortably within the Stability and Growth Pact’s debt ceiling of 60% of GDP. We also indicate how forward-looking budget reaction functions fit into a debt targeting framework.

Keywords: E22; H63; O40; economic growth; golden rule of financing; public capital; public debt

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036846.2013.861590

Affiliations: 1: Fiscal Policies Division, European Central Bank, Frankfurt am Main, Germany 2: School of Public Policy, George Mason University, Arlington, VA, USA 3: European Commission, Brussels, Belgium

Publication date: February 21, 2014

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