A Survey of Existing Theories Related to the Real Effects of Public Debt

         
Author Name SHOJI Keishi  (Graduate School of International and Public Policy, Hitotsubashi University)
Creation Date/NO. June 2013 13-J-040
Research Project Policy Mix for Fiscal Consolidation Without Harming Japan's Economic Recovery
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Abstract

While the Japanese economy has been characterized by historically low interest rates, in the euro area, the sovereign debt crisis has occurred due to the high risk premium required by investors. Recently, the bill related to the Comprehensive Reform of Social Security and Tax, which includes the plan to increase consumption tax, was approved and passed. The discussions that led to the passage largely lacked theoretical support during the process as a result of insufficient research being conducted on the real effects of public debt. This paper reviews theoretical explanations on this topic by referring to existing theories and empirical studies. In addition, by analyzing the spillover effect of fiscal deficits using the vector error correction model, the accumulation of government debt is verified as to whether it has a negative impact on the real economy.

The following conclusion can be drawn from the results of this study: it is possible to set up a hypothesis that public debt accumulation leads to a decrease in the investment toward tangible and intangible fixed capital and in the intermediate inputs, which would in turn cause total factor productivity (TFP) to decline and negatively impact the real economy. The hypothesis further states that such process develops through the following channels: (i) limited supply of funds to the private sector, (ii) increase of real interest rates (and/or) decrease of capital investment due to the decrease in the expected rate of return, and (iii) decline of social capital stock due to the rigidity of the national budget.