Debt as a blessing: A capital screening mechanism

Abstract

We challenge a recently popular view that a negative interest-growth rate gap ( r < g ) offers a “free lunch” for debt-financed government spending by formulating a model in which r and g are endogenous variables shaped by fiscal policy through its effects on equilibrium multiplicity and capital allocation. Observing r < g can signal that sustained government deficits have generated multiple steady states, and the economy has converged to a stable low-efficiency equilibrium. With its heterogeneous entrepreneurs, the model’s real interest rate serves as a screening device for investment efficiency. Causation runs from the fiscal regime to equilibrium selection and outcomes: Fiscal surpluses eliminate equilibrium multiplicity and anchor expectations that sustain a unique, high-productivity equilibrium, thereby rationalizing Alexander Hamilton’s characterization of “debt as a blessing.” Persistent deficits can push the economy into a “misallocation trap” characterized by scarce safe assets, low interest rates, survival of inefficient firms, depressed aggregate productivity, and self-validating low growth. Thus, costs of debt-financed fiscal deficits consist not only of deferred taxes, but also of permanently lower national productive capacity.