3. Should government reduce debt or invest in economic growth?
The best course of action should take these trade-offs into account and is specific to each country. One reason to favour the debt reduction is when the national debt is very high and payment made on servicing the debt is a very large share of total government expenditure. In this case, it is much harder to keep spending at a sufficient level to provide the necessary public services in economic downturns because additional borrowing will not be possible.
Windfall revenue from natural resources can relieve this pressure on government finances. This may reduce interest rates paid on government bonds and improve a country’s rating with investors. These arguments mostly relate to foreign debt. Domestic debt can also be reduced although that should be done less vigorously because domestic government debt also provides a safe investment asset for the domestic banking system. Without it, banks may have to take on more risk, which may reduce stability in the banking system.
If debt levels are low, then growth promoting investment is a better option. Investing in drivers of economic growth such as education, health care and infrastructure may increase the size of the economy over time. For example, infrastructure investment is one of the reasons why counties in the United States could prolong the (temporary) positive effect of the oil field discoveries during the first half of the 1900s.
In turn, a growing economy makes it easier to service national debt and improves debt sustainability. However, this is a relatively slow process and it has its own limitations which are explained in the sections which follow.
Growth promotion is also favoured if the economic base of the economy is narrow and overly specialised in natural resource extraction. The windfall revenue should then be used to diversify the economy. This strategy has contributed to more broad based growth beyond the boom in commodities for example in Mauritius, Malaysia, and Uganda.