What really drives public debt

What really drives public debt

Through the Global Crisis, sovereign debt-to-GDP ratios grew substantially when confronted with shocks to growth, increased fiscal deficits, bank recapitalisation costs, and rising borrowing costs. This column talks about how these various shocks connect to one another to exacerbate or mitigate the eventual effect on debt. Selection of monetary policy regime can be an important determinant of how public debt reacts to these shocks.


Because the Global Crisis, government debt in advanced countries has ballooned from around 70% of GDP in 2007 to over 105% in 2014. The proximate factors behind this rapid upsurge in debt are popular. Deep recessions reduced nominal GDP and caused primary balances to deteriorate; banking sector recapitalisation forced steep changes in your debt level; and perhaps, sovereign bond yields spiked, increasing the price of debt. But what’s less clear is how these various drivers of debt interacted with one another to exacerbate or mitigate the eventual effect on your debt level. The role of monetary policy in these dynamics can be not well understood. An unbiased central bank may have better control over nominal GDP and greater usage of seignorage revenues, and could be better in a position to prevent creditor runs – which should donate to more stable debt. But what difference does this make to advertise sentiment and fiscal policy?

There exists a growing literature that explores the way the the different parts of debt interact individually. For instance, in his seminal paper, Bohn (1998) demonstrates that the united states primary balance reacts positively to your debt level. This, he argues, provides evidence that US sovereign debt will not follow a random walk but reverts for some steady-state level and for that reason is sustainable. Many also have considered how the interest responds to your debt level. Corsetti et al (2014) model sovereign default risk as a function of the length to a ‘debt limit’ – a spot where debt is indeed high a sovereign is no more able or ready to service it. As agents are forward looking, this affects market interest levels in a non-linear fashion.

The role of monetary policy in influencing debt sustainability in addition has been a matter of debate recently. De Grauwe and Ji (2013) show empirical evidence that Eurozone countries (without ‘stand-alone’ central banks) are more vunerable to self-fulfilling liquidity crises. Krugman (2014) illustrates this aspect utilizing a more generalised theoretical framework. However, Hilscher et al. (2014) argue that there surely is little scope to lessen the US’s debt obligations through central bank-generated inflation.

A holistic method of debt dynamics

In recent work, we create a unified framework for focusing on how all of the the different parts of debt – the principal balance, the interest, growth, and inflation – connect to one another (Anaya and Pienkowski 2015). Utilizing a structural vector auto-regression (SVAR) estimator with an endogenous debt accumulation equation, we find that some interactions exacerbate the impact of shocks to the accumulation of debt, while some act to stabilise debt dynamics. Our sample covers 15 advanced economies.

Table 1 summarises the response of key the different parts of debt (columns) to exogenous shocks to the other components (rows). For instance, the principal balance actively reacts to growth shocks and is highly sensitive to changes in the marginal interest. The response of the principal balance to growth shocks is apparently counter-cyclical, which implies that the sovereigns in the sample use active discretionary fiscal policy to greatly help stabilise demand when confronted with growth shocks. In regards to interest shocks, a 1% upsurge in the marginal interest on government debt leads to the average tightening of the principal balance of around 0.7%. This reaction could be explained by governments’ desire to stabilise debt to be able to prevent interest levels increasing to unsustainable levels.

Table 1 . Summary of most countries


Note: 1 Reflects the peak response to the shock.

The need for monetary policy

These sample averages hide more interesting cross-country differences. The decision of monetary policy regime plays a significant role in these debt dynamics. 1 To illustrate this, the sample is split into two. The first category includes sovereigns that don’t have full control over monetary policy, such as for example those in a currency union or with a set exchange rate regime. The next category includes sovereigns that have an unconstrained monetary policy regime, typically ‘inflation targeters’.

The response of the marginal interest to shocks to the principal balance and growth is small, and similar for both monetary policy regime groups. However, the result of marginal interest levels to a shock to debt is more striking (Figure 1).

Figure 1 . Response of the marginal interest from a shock to debt

Note: Debt shock is defined at +10pt.

Carrying out a positive shock to your debt level (perhaps due to bank recapitalisation costs), the marginal interest on the constrained monetary policy group increases sharply, and is persistent for about 1.5 years. This presumably reflects the market’s perception that the credit risk for these sovereigns has materially increased. On the other hand, the marginal interest appears to persistently fall for the unconstrained monetary policy group. This somewhat puzzling result could be related to how these country authorities use monetary policy in such circumstances. These countries might be able to manipulate long-term sovereign rates (perhaps through asset purchase programs or forward guidance) to be able to stabilise debt dynamics.

Perhaps due to the forex market reaction, the response of the principal balance to a shock to the marginal interest is also completely different for both groups. A shock to interest levels typically generates a big and persistent upsurge in the principal balance from countries without full control of monetary policy (Figure 2).

Figure 2 . Response of the principal balance from a shock to the marginal interest

Note: Marginal interest shock is defined at +1pt.

This finding could be explained by the united states authorities’ perception they are more susceptible to a lack of confidence in their capability to control debt, therefore react strongly to any upsurge in marginal borrowing costs. On the other hand, there is without any reaction from countries with an unconstrained monetary policy regime. We find further interesting differences in both of these groups from the many interactions. In addition they explore how these shocks and interactions eventually feed in to the evolution of debt through time.

In conclusion

This column provides some empirical evidence to aid the often-cited opinion that monetary policy matters for sovereign debt sustainability. This analysis also supplies the basis to assess what sort of shock – say, to growth – will impact debt dynamics, directly and through second-round effects (such as for example through the principal balance and interest levels). That is particularly useful for debt sustainability analysis – both with regards to looking at the impact of a detrimental shock to the machine and with regards to assessing the realism of projections.

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