The fundamental question of fiscal policy is how the authorities should manage the public debt; specifically, what time path should they adopt?

Is there an optimal debt–GDP ratio?

Earlier in the book, we discussed the Barro (1979) result that, optimally, the debt–GDP ratio should follow a random walk. The logic behind this result is clear. Firstly, if we think of the adjustment as taking place through tax changes, it is better that taxes stay constant rather than fluctuate. This is for efficiency reasons, to minimize the distortionary effects of taxation. Secondly, given that it has been established that taxes should stay constant over time if possible, the question arises as to what level to set taxes. The answer is that they should be set at a level consistent with a stable debt–GDP ratio over time. Any other rate would mean either a continually increasing or continually decreasing debt–GDP ratio. This cannot happen indefinitely, so there would have to be tax changes in the future, and this cannot be optimal. It follows that whenever there is a shock to the debt, or an event happens which affects the expected time path of the debt–GDP ratio for current levels of taxation, tax rates need to change so that it is expected that the ratio neither increases nor decreases over time.

The Barro result is based on restrictive assumptions, in particular the assumption that there is no possibility of the government ever defaulting on its debt. So there is no critical level of debt, such that default is likely if the debt exceeds it. If there were such a critical level which might provide an upper bound to the debt–GDP ratio, then we probably would not want to go near it. The conclusions of the analysis might be completely changed by relaxing the assumption that the government cannot default. If the critical level of the ratio is 100 per cent, then 90 per cent is perhaps sufficiently close that a few adverse shocks might raise it to 100 per cent. We would also like to have some leeway to pursue expansionary fiscal policies in response either to a shortfall in demand or a major crisis such as the GFC.