Increasing returns and crowding out

This paper explores how public debt interferes with the accumulation of physical capital when the technology displays a production externality of the Arrow-Romer type. We identify conditions under which a small positive amount of debt will prevent the economy from ever approaching the stock of capital that it would achieve if public debt were zero. We also show that the interaction of debt and production externalities may produce bounded (possibly cycling) capital stock sequences in economies where sustained growth rates are possible with zero national debt. Finally, welfare issues concerning the relation between static and dynamic inefficiencies are discussed.