When Is Government Debt Risky?
BERKELEY – A government that does not tax sufficiently to cover its spending will eventually run into all manner of debt-generated trouble. Its nominal interest rates will rise as bondholders fear inflation. Its business leaders will hunker down and try to move their wealth out of the companies they run for fear of high future corporate taxes.
Moreover, real interest rates will rise, owing to policy uncertainty, rendering many investments that are truly socially productive unprofitable. And, when inflation takes hold, the division of labor will shrink. What once was a large web held together by thin monetary ties will fragment into very small networks solidified by thick bonds of personal trust and social obligation. And a small division of labor means low productivity.
All of this is bound to happen – eventually – if a government does not tax sufficiently to cover its spending. But can it happen as long as interest rates remain low, stock prices remain buoyant, and inflation remains subdued? I and other economists – including Larry Summers, Laura Tyson, Paul Krugman, and many more – believe that it cannot.