The constraint on public debt when r < g but g < m Ricardo Reis LSE March 2021 Abstract With real interest rates below the growth rate of the economy, but the marginal prod- uct of capital above it, the public debt can be lower than the present value of primary surpluses because of a bubble premia on the debt. The government can run a deficit forever. In a model that endogenizes the bubble premium as arising from the safety and liquidity of public debt, more government spending requires a larger bubble pre- mium, but because people want to hold less debt, there is an upper limit on spending. Inflation reduces the fiscal space, financial repression increases it, and redistribution of wealth or income taxation have an unconventional effect on fiscal capacity through the bubble premium. JEL codes: D52, E62, G10, H63. Keywords: Debt limits, debt sustainability, incomplete markets, misallocation. * Contact:
[email protected]. I am grateful to Adrien Couturier and Rui Sousa for research assistance, to John Cochrane, Daniel Cohen, Fiorella de Fiore, Xavier Gabaix, N. Gregory Mankiw, Jean-Charles Rochet, John Taylor, Andres Velasco, Ivan Werning, and seminar participants at the ASSA, Banque de France - PSE, BIS, NBER Economic Fluctuations group meetings, Princeton University, RIDGE, and University of Zurich for comments. This paper was written during a Lamfalussy fellowship at the BIS, whom I thank for its hospitality. This project has received funding from the European Union’s Horizon 2020 research and innovation programme, INFL, under grant number No. GA: 682288. First draft: November 2020. 1 Introduction Almost every year in the past century (and maybe longer), the long-term interest rate on US government debt (r) was below the growth rate of output (g).