The optimal debt level is assessed through macroeconomic models focusing on the expected rate of inflation and debt-to-GDP ratio, with Congress setting a legal Debt Ceiling and investor confidence affecting government bond interest rates.
Determining the Optimal Debt Level
The question of how the optimal debt level is determined encompasses several aspects of macroeconomics and finance.
Economists and policymakers utilize different theories and models to assess the sustainability and desirability of a country's debt level.
One significant aspect of this determination comes from understanding the relationship between debt, inflation, and the overall health of an economy.
Former Chairman Ben Bernanke's approach to managing inflation considers the expected rate of inflation as revealed by various indicators, over the next year.
According to this perspective, if the government borrowed money at a fixed interest rate, and lets inflation rise above that interest rate, it would be able to repay its debt at a negative real interest rate, effectively lowering the debt's real value.
However, a rising debt-to-GDP ratio could generate uncertainty in financial and global markets, damaging real wealth, and undermining confidence in a government's fiscal management.
Congress also plays a role by establishing the Debt Ceiling, which is the maximum debt level the U.S. government can legally maintain.
Confidence in government bonds is another crucial factor.
As long as governments pay their debts on time, they will maintain confidence from investors, influencing the interest rates for additional lending.
Debates among economists and politicians frequently occur regarding how much government debt is feasible without negatively impacting the economy.