I examine 12 European countries and find that for all these countries, the optimal policy is to start reducing public debt immediately and continuously until sometime between year 2030 and 2045. The implied optimal budget surplus on average over these years varies between one and four percent of output annually. It is found, maybe surprisingly, that the effects of precautionary saving can be significantly underestimated if labor supply is assumed fixed when it is not. This is the case even if utility is separable in consumption and leisure. The precautionary effects on leisure are similar to those on consumption.
Agents work more today and less tomorrow if risk increases.
Moreover, the standard definition of prudence is shown not to be applicable in the current setting. Consequently, a new definition of prudence is suggested. I examine the effects that variations in public debt and transfers have on risk sharing, efficiency, and the distribution of resources. I find that risk sharing can be improved significantly by both debt and transfers, but that debt has adverse effects on equity. When used in isolation, debt will enhance welfare if transfers are lower than optimal.