The Debt Capacity of a Government

Fiscal costs of excessive debt should be assessed dynamically reflecting anticipated growth, deficits, and interest rates. Studying their joint behavior, with overlapping generations and structural deficits arising from social security, the authors define government debt capacity as the level that can be just sustained with current fiscal parameters unchanged all the way to an unstable steady state, in which primary deficits last forever. Below capacity, debt converges to a stable steady state. Above capacity, debt unravels. Exceeding capacity without unraveling requires higher future taxes or reduced expenditures, which is the true fiscal cost. With money, capacity increases with the target nominal interest rate if the Taylor coefficient is below one. Increasing capacity by subsidizing innovation is challenging as benefits hardly surpass costs.