The vast literature on debt sustainability has recently been enriched by liquidity risk, contagion, implicit and contingent liabilities, tail risks and so on (Debrun 2019). From the vantage point of the EU and especially the euro area members, the policy response to the pandemic crisis adds a key novel dimension, i.e. an ex-post insurance to shocks, this time provided jointly by the ECB and the EU budget. In conjunction with the lifting of the fiscal rules, regulatory changes, and the expansion of national budgets, it is a de facto put option provided by ECB and EU policymakers to support the economy and avoid systemic stress and financial instability, thereby limiting any risk of sovereign default (Bénassy-Quéré and Weder di Mauro 2020).
The monetary component of the European insurance is granted as long as the ECB’s interventions are in line with its mandate to maintain price stability. For now, and the immediate future, national debt is sustainable as the central bank keeps purchasing it. However, once policy objectives start colliding, issues may emerge. Over the longer term, the parameters are so uncertain that the analysis becomes challenging (Corsetti 2018) and the question emerges of how the new post-COVID-19 scenario is best embedded in the Debt Sustainability Analysis (DSA).
A popular argument is that, with extremely low interest rates, the debt-carrying capacity of countries has increased and higher debt-to-GDP ratios are now sustainable. Debt has been on an upward trajectory for more than 30 years in Japan without generating inflation, although impinging on economic growth. What is different about the pandemic crisis? What is different in a monetary union?
A scenario with nominal growth rising faster than debt burden
A simple answer may be that, in light of the Japanese experience, as long as inflation remains low, the central bank can continue to provide the necessary support by purchasing government bonds in the secondary market. In the case of the euro area, by allowing significant temporary deviations from its capital key in the allocation of purchases, the ECB may keep reducing cross-border fragmentation of sovereign debt markets, de facto helping troubled countries.
But what if, at some point, inflation starts to increase again, driving up interest rates? Would that compromise sustainability? Incidentally, one may observe that, if the EU’s investment stimulus works, this may occur sooner rather than later. At that point, for sustainability not to be at risk, nominal growth must remain sufficiently strong to support the rising cost of borrowing.
Nominal GDP growth (as a result of real GDP growth but also the GDP deflator, i.e. inflation), the interest rate burden and the primary balance are closely interconnected. A return of real GDP growth, in the presence of an ultra-accommodative policy, would likely lift inflation, everything else equal. Monetary policy would have to react pre-emptively to reduce inflation risk, raising the cost of sovereign borrowing. These two factors have opposing effects on the debt-to-GDP level. Hence, there will be a narrow path for rate normalisation, beyond which debt sustainability will require very strong adjustment in primary surpluses.
The key questions then are:
- What are central banks going to do when inflation starts increasing as a result of the massive fiscal stimulus?
- How long can governments’ policies remain credible amid rising debt-to-GDP ratios, with financial markets pricing bonds accordingly?
The answers are far from straightforward. It is the job of central banks to keep rates as low as needed for as long as required to reach their objectives. With a two-year-out inflation forecast below 1.0%, the ECB has plenty of work to do. For as long as the ECB continues to perform quantitative easing (QE), markets will stay calm. Evidence from the past 25 years shows that, if anything, inflation risk has hardly moved upward. There is an argument for central banks to err on the side of caution and/or aim for inflation overshooting (as the Fed seems to pursue now), supporting fiscal policy along the way.
However, this time the European fiscal stimulus is, at least on paper, massive by historical standards, and for good reasons. Moreover, current supply-side changes driven by politics and COVID-19 are likely to modify both upside and downside risks to price stability. Deglobalisation and the effects of the pandemic are likely to translate into a structural increase in the level of costs and prices. This would not necessarily trigger a monetary policy reaction, but central banks will have to make sure price and cost adjustments do not ignite persistent drifts bringing inflation expectations well beyond target.
The damage to aggregate supply due to higher costs should not be underestimated. A permanently lower output potential means that a modest increase in demand may already build tensions on prices. That said, considerable uncertainty is likely to weigh on precautionary savings by households and corporates, keeping aggregate demand below aggregate supply, and therefore counteracting inflationary pressure from rising costs for a non-negligible time span. Central banks, and the ECB in particular, are likely to manage rate normalisation with a substantial dose of caution – again, while still supporting fiscal policy via market interventions.
The response to COVID-19 in a (now less) incomplete monetary union
Market fragmentation within the euro area and different paces and magnitudes of economic recovery across member states present a further complication. If a large country like Italy remains a laggard (as it did in the past crisis episodes), the recovery divide across borders would once again be a significant problem for the euro area as a whole. It would trigger calls for an early tightening of fiscal policy and possibly managed debt restructuring, both undesirable but eventually inevitable steps in the absence of effective correction.
Zooming back to 2010-2011, if the euro area had to face the current crisis with the institutions, governance, beliefs and politics prevailing then, there would be a severe threat to the survival of the euro. But things have changed, and much water (and liquidity) has flowed under the bridge. While imbalances remain and even grow in some cases, the monetary union is less incomplete and fragile than it was.
Sustainability ahead: Context and conditions
At the end of this very unusual period, will government debt emerge in better shape, or will only default/restructuring or inflation be able to re-establish sustainability?
As the central bank is heavily buying government papers, financial markets are no longer able to price the risk of default relying on traditional indicators as the metric provided by these is heavily distorted. Analogously, traditional DSA may be misleading given the high uncertainty about economic growth, the effect of past-COVID-19 policies and the length of the current below-zero interest rate environment. Taking into account today’s financial market expectations and what we know about the economy, policymakers will have to decide how far they can go in supporting the economy through the fiscal side.
As Italy is a major country in the euro area, and its high public debt-to-GDP ratio could potentially be destabilising, we focus on a simple exercise on the country’s debt to highlight some key considerations in the current economic environment. Here is the exercise:
- We take the amount of the Recovery and Resilience Facility (RRF) as it emerged from the negotiations among prime ministers in July (almost 90% of the €750 billion package). We rescale the fiscal package and spread the stimulus according to the timeline proposed by the Commission to obtain estimates of investment spending over the next seven years (2021-2027). We assume that all the new resorces will be used for additional spending, although the RRF allows for a fraction of the money to be used in line with EU priorities on existing (already budgeted) projects.
- We apply reasonably conservative multipliers. Estimates of multipliers vary widely in the literature and in the work of international organisations, although those used for public capital tend to be higher than generic multipliers for public spending (Izquierdo et al. 2019). In 2019, a paper by economists from the Bank of Italy suggested various scenarios for multipliers. We take the most conservative estimates, which call for ‘reduced efficiency investment’ defined as a scenario in which only half of the overall fiscal package produces an increase in the stock of capital. The rest is considered non-productive spending, with a smaller impact on economic activity than capital accumulation. This may also happen if the investment gives very long-term returns, like investment on education, or reduces potential future damages without enhancing potential growth, like many climate transition measures. The multipliers used are 0.5 after the first year, 0.7 in the second, and 0.8 in the third and following years.
- We assume a long-term potential growth rate of 0.6% for Italy, an immediate hit of 0.2 percentage points due to the pandemic shock, and a gradual increase by 0.4 percentage points over time due to the massive EU investment plan spread over seven years, bringing the potential to 0.8% over the long run.
- We assume a somewhat lagged policy reaction by the ECB, with a total of a 3.0 percentage point rise in short-term interest rates over 2024-26 (1.0 percentage points a year), with a parallel move in the yield curve. The increase in rates has a moderate and lagged negative effect on economic activity and the GDP deflator eventually returns to a value close to the ECB’s inflation target at close-but-below 2.0%. Once the GDP deflator is close to 2%, real short-term interest rates will be close to 1% and long-term real interest rates to 2%.
While the exercise is very stylised and oversimplified, it still produces some interesting results:
- The RRF is a package of fresh stimulus worth up to 12% cumulatively of GDP for Italy (in excess of €200 billion). The stimulus is in excess of 10% for 14 countries, above 14% for three countries, and close to 5% for the overall euro area. On top of that, there will be massive national investment plans (Germany and France, for instance).
- A sustainable fiscal outlook over the next few years will rest on: (a) the possibility to achieve returns from the investment within a reasonably short-time horizon; and (b) the use of the resources to increase the productive stock of capital. These two conditions determine the strength of the multipliers – most crucially, whether the investment plans will have permanent ‘level effects’ on the economy, and in turn on fiscal revenues.
- A somewhat lagged and moderate reaction by the ECB would not derail the economic recovery and not disrupt a return to a steady decline for Italy’s debt-to-GDP ratio. The implicit cost of borrowing minus the nominal GDP growth rate will stay negative for several years and only turn marginally positive eventually.
Figure 1 Italy: Real GDP projections and the impact of the EU’s Recovery and Resilience Facility
Figure 2 Italy: Cost of borrowing vs nominal GDP growth
Many years ago, Samuelson criticised “pump-priming […] acting as a catalyst to speed the upward movement of investment … or form the spark to ignite business activity …” This warning is still very much valid.
However, today’s environment is somewhat special:
- Nominal interest rates are at zero, or below zero, for AAA sovereign issuers and for the EU.
- The multipliers can be expected to be higher than usual, due to a substantial shock to public investment in Italy.
- The low-inflation environment is unlikely to suddenly turn, thus requiring only a lagged and moderate reaction once inflation starts moving higher as a result of the stimulus.
- All EU/euro area countries are introducing a broadly similar fiscal stimulus through investment at the same time―spillovers will hence reinforce the effect on GDP growth at national level.
- The duration and maturities of public debt have been lengthened over the years, allowing a long period of very low debt servicing costs.
- For many EU countries, the fiscal stimulus (the grant component) does not deteriorate the debt-to-GDP ratio (leaving aside what will be paid at some point through EU taxation).
By contrast, if investment activity is not efficient and multipliers prove to be much lower, or the monetary policy reaction is more substantial and quicker, then sustainability issues will emerge. But the possibility of financing potentially growth-enhancing and tax revenue-enhancing investments at zero nominal (and low real) rates for an extended period makes DSA today look quite different then in the past.
Bénassy-Quéré, A and B Weder di Mauro (2020), "Europe in the time of COVID-19: A new eBook", VoxEU.org, 22 May.
Busetti, F, C Giorgiantonio, G Ivaldi, S Mocetti, A Notarpietro and P Tommasino (2019), “Capitale e investimenti pubblici in Italia: effetti macroeconomici”, Questioni di Economia e Finanza (Occasional Papers) n. 520.
Corsetti, G (2018), “Debt Sustainability Analysis: State of the Art”, Study requested by the ECON Committee of the European Parliament, Economic Governance Support Unit Directorate-General for Internal Policies of the Union.
Codogno, L and P van den Noord (2020), “Going Fiscal? A stylised model with fiscal capacity and a Eurobond in the Eurozone”, Amsterdam Centre for European Studies Research Paper No. 2020/3.
Debrun, X, J D Ostry, T Willems and C Wyplosz (2019),"The art of assessing public debt sustainability”, VoxEU.org, 9 December.
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Guerrieri, V, G Lorenzoni, L Straub, I Werning (2020), “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?”, NBER Working Paper No. 26918.
Izquierdo, A, R Lama, J P Medina, J Puig, D Riera-Crichton, C Vegh and G Vuletin (2019), “Is the Public Investment Multiplier Higher in Developing Countries? An Empirical Exploration”, IMF Working Paper WP/19/289.