The Impact of Deficit Fluctuations on Long-Run Government Debt Dynamics
Submitting InstitutionLondon Business School
Unit of AssessmentBusiness and Management Studies
Summary Impact TypeEconomic
Research Subject Area(s)
Economics: Economic Theory, Applied Economics, Econometrics
Summary of the impact
Andrew Scott and co-authors have examined how government debt should
respond to economic shocks. Their research shows incomplete debt markets
should show large and long-lasting re-sponses: a 3-4 year financial crisis
should generate a swing in debt over 20-30 years. This work has impacted
European governments, Finance Ministers and Permanent Secretaries of the
G7, the UK Debt Management Office, and others. In summary: cutting-edge
research has impacted the contemporary thinking of policymakers as they
formulate government debt management.
The underpinning research was conducted over the past decade, and key
outputs have been published in scholarly journals. Andrew Scott is central
to both the original research and the subsequent policy-relevant
dissemination and impact of it. Over the relevant period his work has been
based at London Business School where he is a Professor of Economics.
The central underpinning research was reported in the Journal of
Economic Theory: "Debt and deficit fluctuations and the structure of
bond markets." Albert Marcet and Andrew Scott showed that when a
government pursues an optimal fiscal policy under complete markets, the
value of debt has the same or less persistence than other variables. In
contrast, and importantly, under incomplete markets debt shows more
persistence than other variables and it increases in response to
deficit-causing shocks. Data for US government debt reveal opposite
results from those of complete markets, and those data are much more
supportive of bond market incompleteness.
A further underpinning contribution was reported in the Economic
Journal: "Fiscal insurance and debt management in OECD economies."
Marcet, Scott, and Elisa Faraglia asked and answered these questions: (i)
what indicators can be used to assess the performance of debt management?
(ii) how well have historical debt management policies performed? (iii)
how is performance af-fected by variations in debt issuance? Using OECD
data between 1970 and 2000, they proposed performance indicators for debt
management, and evaluated them using Monte Carlo analysis. Those based on
the relative persistence of debt performed best. There is only limited
evidence that debt management has helped insulate policy against
unexpected fiscal shocks.
A third development was published in the Journal of Monetary
Economics: "In search of a theory of debt management." It argues for
a theory of debt management that incorporates market incom-pleteness. The
complete-market approach recommends huge fluctuations in positions,
enormous changes in portfolios for minor changes in maturities, and other
volatile features. The fragility of portfolios to small changes or the
presence of transaction costs means that a balanced budget can outperform
the large positions that the complete-markets approach recommends.
Furthermore, the complete-market recommendations conflict with features
that are integral to bond-market in-completeness, for example transaction
costs, liquidity effects, robustness, and so on.
If adjustment occurs over the long run the issue is how is this achieved?
The NBER paper by Chryssi Giannitsarou and Andrew Scott (2006, NBER)
studies the G7 over the period 1965 to 2008 and finds that the adjustment
comes from changes in the primary deficit.
Finally, research on the coordination between fiscal and monetary
policies has been published very recently in the Economic Journal:
"The impact of debt levels and debt maturity on inflation." Faraglia,
Marcet, Scott, and Rigas Oikonomou showed that under coordination,
inflation persis-tence and volatility depend on the sign, size and
maturity of debt. Higher debt leads to higher inflation and longer
maturity leads to more persistent inflation although inflation plays a
minor role in achieving fiscal sustainability. Under an independent
monetary authority, inflation is higher, more volatile and more persistent
and plays a significant role in achieving fiscal solvency.
References to the research
"Debt and deficit fluctuations and the structure of bond markets," Albert
Marcet and Andrew Scott, Journal of Economic Theory 144(2), March
2009, pp. 473-501. dx.doi.org/10.1016/j.jet.2008.06.009
"Fiscal insurance and debt management in OECD economies," Elisa Faraglia,
Albert Marcet, and Andrew Scott, Economic Journal 118(527), March
2008, pp. 363-386. dx.doi.org/10.1111/j.1468-0297.2007.02125.x
"In search of a theory of debt management," Elisa Faraglia, Albert
Marcet, and Andrew Scott, Journal of Monetary Economics 57(7),
October 2010, pp. 821-836. dx.doi.org/10.1016/j.jmoneco.2010.08.005
"Inflation implications of rising government debt," Chryssi Giannitsarou
and Andrew Scott, National Bureau of Economic Research w.p. 12654,
October 2006; also NBER International Seminar on Macroeconomics,
(2006), pp. 393-439, University of Chicago Press ISSN 19328796.
"The impact of debt levels and debt maturity on inflation," Elisa
Faraglia, Albert Marcet, Rigas Oikonomou, and Andrew Scott, Economic
Journal 123(566), February 2013, pp. F164-F192.
Evidence of quality. The Journal of Monetary Economics
(JME) is the leading field journal in macroeconomics; the Journal of
Economic Theory (JET) is the leading field journal in economic
theory; and the Economic Journal (EJ) is a leading
general-interest journal and also the UK's top economics journal. All were
rated as "4?" outlets by the ESRC-RES benchmarking review of UK
Economics. In the Combes-Linnemer ranking, these outlets are "AA" rated,
and rank at positions 7, 9, and 12. The fourth research output is
disseminated by the prestigious National Bureau of Economic Research.
All outputs listed here have been cited extensively.
Details of the impact
Context. An impact of the global financial crisis is that
government debt will be high for decades to come, and this is seen as a
serious problem. However, economic theory only relates the value of debt
today to future primary surpluses; it does not necessarily say that debt
is too high or that debt reduction should be a short-term priority. Rises
in debt do reflect economic problems; but given the recent shocks, we
might be better off with high debt for a longer period.
Relevant research findings. If bond markets are incomplete then
debt should act as a buffer to help accommodate temporary shocks, and debt
should show large and long-lasting swings: the underpinning research
demonstrates that government debt should show decade-long shifts, and that
optimal swings may even appear unsustainable—even though, by design, they
are not. Furthermore, debt does not revert back to its previous level.
Rather than abruptly raise taxation and cut government expenditure, fiscal
policy should adjust over the long term. Fiscal adjustment in the short
run is not enough to produce a surplus and so debt rises for a signifcant
Beneficiaries. The two beneficiaries are (a) government
policymakers and (b) observers within the wider financial markets. Group
(a) includes the UK Government, via the Office for Budget Respon-sibility;
the wider group of European governments and policymakers; and the finance
ministers of the G7. Group (b) includes financial market participants such
as credit reference agencies.
Nature of the impact. The research findings have allowed
beneficiaries in group (a) to under-stand that current debate places too
much emphasis on rigid fiscal discipline, and has allowed beneficiaries in
group (b) to understand that longer-lasting debt may be optimal.
(a). Governments should, of course, look at long-term solvency and
articulate a plan for debt stability. But the imposition of hard numerical
targets and dates is a mistake. If further shocks occur or the crisis
continues it will optimal to revise these targets. Debt accommodates
shocks— making policy change to meet previously fixed fiscal targets puts
the cart before the horse.
(b). Markets, credit rating agencies, and deficit hawks need to recognise
that government debt will and should remain at its elevated level for a
long time and the required adjustment is for the long haul. Fiscal
discipline and solvency is not inconsistent with decade-long shifts in
debt. Widespread publicity has allowed this message to be received by such
The impact process. The research findings have achieved recent
impact amongst government pol-icymakers (the first group of beneficiaries)
and have been publicised via the wider non-academic press (so impacting
the second group of beneficiaries). The process of this impact has been
directly from the key author of the research (Andrew Scott) to the
Instances of the process and means through which the research had impact
are as follows.
(i) Europe. The findings were promoted to governments throughout
Europe. Andrew Scott was selected by the CEPR to give one of two policy
briefings in Brussels to European policymakers. Relatedly, he presented
his debt management work to the European Central Bank in May 2011.
(ii) UK Treasury. The United Kingdom Treasury invited Andrew
Scott to give two presentations— one on fiscal policy, and one on debt
management—in March and September 2011.
(iii) UK Debt Management. A seminar on debt management, which
specifically communicated the research findings, was given to the United
Kingdom Debt Management Office in June 2012.
(iv) Bank of England. The Bank of England arranged a special
session (RES Session 47) "Interac-tions between Monetary and Fiscal
Policy" conference, chaired by Charlie Bean (Deputy Governor, Monetary
Policy) on debt management at the Royal Economic Society on 19 April 2011.
Scott's work was presented at the request of the Bank; this session was
assembled by Spencer Dale (Chief Economist, Bank of England).
(v) G7. This research was presented as part of a weekend with G7
Finance Ministers and their Deputies in Rome in June 2010, hence impacting
(vi) OBR and FSA. Andrew Scott directly used his research
findings in policymaking: he is a member for the expert advisory panel of
the UK's Office for Budget Responsibility; he was non-executive director
of the Financial Services Authority (2009-13) and chair of the FSA Risk
The high level of sovereign debt and the significant amounts held by the
European banking system is an obvious risk to the financial system.
Andrew's research suggests that these problems would get even more serious
in years to come and formed a direct input into this questioning of stress
testing and risk scenarios at the FSA.
(vii) General impact. This research has achiever wider impact
outside academic populations via publication in the general press and
other outlets. For example, the key messages appeared in the Financial
Times and were disseminated via voxeu.org and other channels. See:
- "A new watchdog would guard us from debt," The Times, 15
- "US and UK can handle decades of debt," Financial Times, 28
- "The long wave of government debt," voxeu.org, 11 March 2010.
Sources to corroborate the impact
Contact details for specific named personnel (in the Bank of England, HM
Treasury, the International Monetary Fund, and the CEPR) who can
corroborate the claims of (i)—(vi) are provided in the supplement to this
case study. Those contacts include a current Monetary Policy Committee
member and others at the very highest level of policymaking.