As forcefully documented by Reinhart and Rogoff (2009, 170), financial crises associated with banking crises (as the 2007-2009 global financial crisis) leave heavy fiscal legacies: the real stock of government debt nearly doubles three years after the crisis. For the USA an increase in the gross government debt to GDP ratio towards more than 100% is predicted by 2012 (OECD 2011). In contrast, the debt to GDP ratio in fast growing emerging countries like China will recede to below 10% by 2020 (IMF 2011). As a consequence, the IMF (2011) strongly recommends government debt reduction in the USA and other highly indebted advanced countries. In light of these empirical observations, the ‘old’ theoretical question of the impacts of government debt reduction in one part of the world economy on its international competitiveness (as measured by its real exchange rate) and on the domestic and foreign welfare becomes relevant again. However, the technological characteristics of the world economy today differ significantly from the world economy in the 1980s when there was also a huge change in US federal debt: nowadays there are significant technological differences between the highly indebted countries and those countries affected through the debt reduction, in particular emerging countries like China. For example, Bai and Qian (2010) report a nearly 50% production share of capital in China while the US share is below 30% (Caselli and Feyrer 2007). Moreover, in the post-crisis era dynamic inefficiency prevails, while in the first decade of the 21st century, before the outburst of the crisis, the world economy was nearly at the Golden Rule (IMF 2011). Thus, there are two main objectives of the paper: First, to explore how the real exchange rate responds to a significant reduction of government debt in an advanced country like the USA with a huge negative external balance and a considerably lower capital production share than emerging countries such as China. Second, how do domestic and foreign welfare in the long run change in response to domestic debt reduction when the world economy is not dynamically efficient, but near the Golden Rule or dynamically inefficient?
Methods
To pursue the objectives, a two-good, two-country Diamond (1965) OLG model with technological differences across countries (e.g. USA, China) and opposite external balances will be developed. It will be used to analyse the real exchange rate and welfare effects of domestic government debt reduction in the steady state and along the transition towards it. Both countries in the model economy are interconnected through free trade in commodities and in bonds emitted by national governments.
Expected Results
We find that the real exchange rate effects of a national public debt shock depend on international differences in capital production shares and the dynamic (in)efficiency of the world economy. Under Golden Rule the domestic (foreign) welfare increases (decreases) with decreasing domestic debt when the domestic capital income share is less than Foreign’s and Home is a net foreign debtor, whereas under dynamic inefficiency the welfare impact is ambiguous.