The Welfare Effects of Debt: Crowding Out and Risk Shifting: Working Paper 2022-10

By Michael Falkenheim.

Government debt affects people’s welfare through two distinct channels: It crowds out capital, and it shifts risk from current to future generations. This study extends Olivier Blanchard’s 2019 analysis of the welfare effects of debt by decomposing his estimates into those two categories. Blanchard estimated the change in average utility under simulations of an overlapping generations model with and without a transfer of wealth from the younger to the older generation. This study decomposes those estimated welfare effects into crowding-out and risk- shifting components and estimates total effects and separate effects of the two components under alternative assumptions about technology and preferences. Even though crowding out can increase welfare under some conditions in overlapping generations models by reducing the overaccumulation of capital, I estimate the crowding-out effect of debt on welfare to be consistently negative. Government debt shifts risk to future generations by giving certainty to current generations that are saving for retirement at the expense of greater risk to future generations. I find the risk-shifting effect of debt on welfare to be positive under Blanchard’s assumptions about technology and preferences, and that positive effect partially or fully offsets the cost of crowding out on the total welfare effect of risk-free transfers. Under alternative assumptions—persistent technology shocks and a greater aversion to intergenerational risk— risk-free debt is much more costly than under Blanchard’s assumptions, partly because the crowding-out effect is larger and partly because risk shifting has negative rather than positive effects.