In a thought-provoking paper, Blanchard (2019) argued that higher debt-to-GDP levels might have become more sustainable than in the past: “When the safe interest rate is less than the growth rate […] both the fiscal and welfare costs of debt may then be small, smaller than is generally taken as given in current policy discussions” (Blanchard 2020).
Today, the possibility of persistently and structurally higher inflation and interest rates undermine residual hopes for a ‘different paradigm.’ In today’s uncertain environment, with inflation spiking, central banks have little choice but to frontload interest rate rises in an attempt to maintain credibility and avoid de-anchoring expectations and a price-wage spiral. The critical consequence is a sudden and sharp rise in the expected long-term cost of sovereign borrowing. Our new paper (Corsetti and Codogno 2022) argues that we are back to the old debt-sustainability fundamentals.
More challenging for the ECB to extend a credible safety net
In the past, the ECB implemented quantitative easing by buying bonds in excess of the government’s financing needs. ECB actions were de facto helping troubled high-debt countries by keeping low government bond yield spreads vis-a-vis perceived risk-free German benchmarks. With inflation persistently below target, these interventions remained aligned with the ECB’s mandate to maintain price stability. A widespread argument was that the ECB could even err on the side of caution and aim for an inflation overshooting, supporting fiscal policy along the way.
With the central bank heavily buying government paper, financial markets could no longer price the risk of default by relying on traditional indicators since their metric was heavily distorted. We argue that financial markets were under ‘anaesthetic’: national debt was sustainable by definition as the central bank committed to purchase it in large amounts.
Now policy objectives are colliding. The need to counteract the spike in inflation forces the ECB, along with most other central banks, to increase interest rates. To the extent that it may also require ‘quantitative tightening,’ yields and spreads may grow higher over time.
Along with its renewed commitment to price stability, the ECB aims to avoid fragmentation in the transmission of monetary policy, i.e. to maintain government bond spreads within certain undisclosed thresholds. First, in explaining its reinvestment policy, the ECB stated: “Redemptions coming due in the PEPP portfolio are being reinvested flexibly, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic” (8 September 2022). Second, it set up a new Transmission Protection Instrument “to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate”.
These policies may well be able to maintain the component of government bond spreads related to credit risk under control. But the situation may become tricky.
Debt sustainability: This time is no different
To illustrate today’s change, hereafter, we compare two ‘worlds’, factoring in the current significant shifts in the long-term equilibrium of the key variables that matter for sustainability. We focus on the debt-to-GDP ratio as the key indicator of sustainability. While being aware of the limits of this approach (e.g. Corsetti 2018), we take a basic conventional view: if there is no tendency for the debt ratio to increase over time, we deem it ‘sustainable’.
We carry out our comparison graphically in Figure 1. The lines in the figure show how the debt-to-GDP evolves (on the y axis) as a function of the existing level of debt, b (on the x axis). The slope of the lines is given by the difference between the real interest rate and the growth rate, , which can be positive or negative. The starting position of the debt ratio is point A.
Consider the world before the recent inflation spike. According to the academic and policy views arising before the COVID-19 pandemic and after the EU COVID-19 recovery package (NextGenerationEU, or NGEU), growth was supposed to be supported for several years by policy measures, while inflation was due to return to target gradually. Monetary policy could have reverted to neutral rates over time, even erring on the cautious side as the inflation risk was perceived to be low. With the real interest rate below real GDP growth, the slope of the debt growth line in the graph was expected to remain negative. In this world, even with an outstanding deficit, debt naturally falls as a ratio to GDP, i.e. the scenario underlying Blanchard’s argument.
Now we turn to the new world. To the extent that a prolonged increase in energy prices makes expected inflation persistently high and potential growth lower, the real interest rate would move above the real rate of GDP growth, . With the slope of the debt growth line turning positive, the debt ratio rises, unless the government runs a primary surplus (a negative that is large enough to offset the interest rate/growth dynamics.
In a scenario in which the government has little control over the sign of , it would be up to fiscal policy to stabilise the debt ratio by reducing the primary deficit or moving into a surplus position. This would shift the line in the graph downward without altering the underlying debt dynamics (i.e. the slope of the line remains positive). Unless the primary surplus is very large, the economy will stay on a path of an ever-increasing debt ratio.
Figure 1 The government debt ratio in the old and new world
The role of expectations in financial markets
Relative to current circumstances, stabilising the debt ratio would become much more challenging if financial markets were to change their expectations about long-term equilibrium real interest rates and potential GDP growth. A change in the long-term view would have immediate repercussions. The market reaction would be swift, with a call for a much higher risk premium on government bonds of vulnerable countries, forcing some policy reaction in the form of tighter fiscal policy. This would be in a context where some fiscal support for cyclical and structural reasons would instead be highly needed. As higher sovereign spreads drive up the borrowing costs of firms and households and deteriorate domestic financial conditions and the resilience of financial intermediaries, the country would enter a ‘bad equilibrium’, where adverse expectations are ex post validated by a persistent downturn plagued by continuing financial turmoil.
To be clear: a stable path forward would still be possible. However, stability would crucially rest on (a) achieving higher potential GDP growth by the end of the NG-EU programme, and (b) maintaining yield spreads under control by credible budgetary policies in a cooperative euro-area-wide policy setting.
Italy as a case study
In April 2021, the Italian government projections foresaw a sizeable rebound in GDP in 2021 (6.0%), with growth remaining well above par for the whole projection horizon (4.7% in 2022, 2.8% in 2023 and 1.9% in 2024). This growth was partly due to the NG-EU programme, expected to produce a sizeable demand stimulus for several years. On the supply side, investments and structural reforms were expected to boost potential growth to 1.5% over the medium term (i.e. to 2024). At that time, the rise in inflation had just started, and the ECB had not yet considered increasing rates. As a result, the nominal interest rate was expected at 2.2% in 2021; deflated using the projected GDP deflator of 1.7%, the real rate was as low as 0.5%. The debt ratio was expected to decrease from 155.6% of GDP in 2020 to 146.1% in 2024, driven by a decline in the primary deficit from 6.0% of GDP in 2021 to 0.8% in 2024.
The same exercise using data from Italy’s official planning document, the 2022 Economy and Financial Document, unveiled in September 2022 introduces a key change. While the debt ratio in 2024 is still projected to decline (to 140.9%), and real GDP growth remains at 1.5% in 2025, the nominal interest rate rises to 2.8% and the GDP deflator to 1.9%, implying a real interest rate on public debt of 0.9%. The debt dynamics are less favourable, but the debt ratio keeps (more slowly) improving. This is due to the primary balance, expected to swing from a deficit to a surplus of 0.7% at the end of the forecast period.
Is it reasonable to expect real interest rates to remain so low over the long run, especially considering the sizeable 2.5% credit spreads already recorded at the time of our writing? Suppose that inflation (measured by the GDP deflator) remains at the ECB’s target of 2.0% over the long run, real GDP at 1.3% (a revised estimate of potential growth by the government assuming 0.6% potential before COVID-19, plus a 0.5 percentage point effect of extra investments, and a 0.3 percentage point effect of reforms) and real interest rates at 1.0% plus a 2.0% risk premium, so that real borrowing costs would rise to 3.0%. In this scenario, would become positive at 2.4%. Stabilising the debt ratio at its 2024 projected level of 140.9% would require a sustained primary surplus.
Similar to other high-debt countries, Italy is at risk of entering a ‘bad equilibrium,’ whereas a higher risk premium driving up the real rate would require potentially self-defeating tightening policies that may end up worsening near-term economic activity and the fiscal outlook of the country. A downturn with fiscal and financial stress, given the evidence of a strong correlation between private and public borrowing costs, risks becoming a self-fulfilling prophecy. A bad equilibrium could easily turn into an unsustainable trend for the debt ratio (e.g. Corsetti et al. 2013).
The macroeconomic environment and mood prevailing in 2020 and the beginning of 2021 were somewhat unique and are over. Just a couple of years later, the global macroeconomic outlook has changed completely. No major central banks can tolerate higher inflation and so all need to raise their policy rates. Not only is this required by their inflation-fighting mandate, but failing to do so, would allow inflation and inflation expectations to drift higher. It would end up raising long-term borrowing costs via an inflation premium (requiring painful disinflationary policies in the future).
In Europe, the adverse effects of the current terms-of-trade shock magnify debt sustainability risks for both public and private debt, thereby driving up credit risk premia. Historical evidence suggests that these premia tend to increase exponentially rather than linearly, exacerbating the rise in the cost of borrowing. It may be argued that, for a long time, the ECB deliberately compressed risk premia with quantitative easing. With the end of net asset purchases, risk premia are no longer anchored by the early QE policies pursued by the ECB. The potential consequences may be mitigated by the NGEU’s money cheaply financing the most vulnerable countries and the ECB’s Transmission Protection Instrument. Yet, the success of these policies is most likely predicated on the ability of member states to enhance their policy credibility and adjust their primary balances.
A sustainable fiscal outlook will rest on two pre-conditions over the next few years. First, reforms and investments should be accelerated to benefit from returns within a reasonably short time horizon. Resources should be devoted to increasing productive capacity, i.e. the stock of physical and human capital, and pursue efficiency in their utilisation. Raising potential growth sooner than previously projected will be crucial to sustainability. Second, a prudent fiscal policy and a smart macro prudential policy are of the essence to reduce, and possibly rule out, the risks of sudden shifts in financial market sentiment that would push government debt into a ‘bad equilibrium.’
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