VoxEU Column Macroeconomic policy Monetary Policy

What really drives public debt

During the Global Crisis, sovereign debt-to-GDP ratios grew substantially in the face of shocks to growth, increased fiscal deficits, bank recapitalisation costs, and rising borrowing costs. This column looks at how these various shocks interact with each other to exacerbate or mitigate the eventual impact on debt. Choice of monetary policy regime is an important determinant of how public debt reacts to these shocks.

Since the Global Crisis, government debt in advanced countries has ballooned from around 70% of GDP in 2007 to over 105% in 2014. The proximate causes of this rapid increase in debt are well known. Deep recessions reduced nominal GDP and caused primary balances to deteriorate; banking sector recapitalisation forced steep changes in the debt level; and in some cases, sovereign bond yields spiked, increasing the cost of debt. But what is less clear is how these various drivers of debt interacted with each other to exacerbate or mitigate the eventual impact on the debt level. The role of monetary policy in these dynamics is also not well understood. An independent central bank may have better control over nominal GDP and greater access to seignorage revenues, and may be better able to prevent creditor runs – all of which should contribute to more stable debt. But what difference does this make to market sentiment and fiscal policy?

There is a growing literature that explores how the components of debt interact individually. For example, in his seminal paper, Bohn (1998) demonstrates that the US primary balance reacts positively to the debt level. This, he argues, provides evidence that US sovereign debt does not follow a random walk but reverts to some steady-state level and therefore is sustainable. Many have also considered how the interest rate responds to the debt level. Corsetti et al (2014) model sovereign default risk as a function of the distance to a ‘debt limit’ – a point where debt is so high that a sovereign is no longer able or willing to service it. As agents are forward looking, this affects market interest rates in a non-linear fashion.

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

A holistic approach to debt dynamics

In recent work, we develop a unified framework for understanding how all of the components of debt – the primary balance, the interest rate, growth, and inflation – interact with each other (Anaya and Pienkowski 2015). Using 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 others act to stabilise debt dynamics. Our sample covers 15 advanced economies.

Table 1 summarises the response of key components of debt (columns) to exogenous shocks to the other components (rows). For example, the primary balance actively reacts to growth shocks and is highly sensitive to changes in the marginal interest rate. The response of the primary balance to growth shocks appears to be counter-cyclical, which suggests that the sovereigns in the sample use active discretionary fiscal policy to help stabilise demand in the face of growth shocks. In regard to interest rate shocks, a 1% increase in the marginal interest rate on government debt leads to an average tightening of the primary balance of around 0.7%. This reaction may be explained by governments’ desire to stabilise debt in order to prevent interest rates increasing to unsustainable levels.

Table 1. Summary of all countries

    Primary balance1 Marginal interest rate1 Debt-to-GDP ratio1



Primary balance (positive shock) 1.00 0.04 -1.25
Real growth (negative shock) -0.60 0.01 1.60
Marginal interest rate (positive shock) 0.7 1.00 0.45
Debt-to-GDP ratio (positive shock) 0.21 -0.04 1.00

Note: 1 Reflects the peak response to the shock.

The importance of monetary policy

These sample averages hide more interesting cross-country differences. The choice of monetary policy regime plays an important role in these debt dynamics.1 To illustrate this, the sample is divided into two. The first category includes sovereigns that do not have full control over monetary policy, such as those in a currency union or with a fixed exchange rate regime. The second category includes sovereigns which have an unconstrained monetary policy regime, typically ‘inflation targeters’.

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

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

Note: Debt shock is set at +10pt.

Following a positive shock to the debt level (perhaps as a result of bank recapitalisation costs), the marginal interest rate on the constrained monetary policy group increases sharply, and is persistent for around 1.5 years. This presumably reflects the market’s perception that the credit risk for these sovereigns has materially increased. In contrast, the marginal interest rate seems to persistently fall for the unconstrained monetary policy group. This somewhat puzzling result may be attributed to how these country authorities use monetary policy in such circumstances. These countries may be able to manipulate long-term sovereign rates (perhaps through asset purchase programs or forward guidance) in order to stabilise debt dynamics.

Perhaps as a result of this market reaction, the response of the primary balance to a shock to the marginal interest rate is also very different for the two groups. A shock to interest rates typically generates a large and persistent increase in the primary balance from countries without full control of monetary policy (Figure 2).

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

Note: Marginal interest rate shock is set at +1pt.

This finding may be explained by the country authorities’ perception that they are more vulnerable to a loss of confidence in their ability to control debt, and so react strongly to any increase in marginal borrowing costs. In contrast, there is virtually no reaction from countries with an unconstrained monetary policy regime. We find further interesting differences in these two groups from the various interactions. They also explore how these shocks and interactions eventually feed into the evolution of debt through time.

In summary

This column provides some empirical evidence to support the often-cited opinion that monetary policy matters for sovereign debt sustainability. This analysis also provides the basis to assess how a shock – say, to growth – will impact debt dynamics, directly and through second-round effects (such as through the primary balance and interest rates). This is particularly useful for debt sustainability analysis – both in terms of looking at the impact of an adverse shock to the system and in terms of assessing the realism of projections.


1. There are a number of reasons why the presence of an independent monetary policy regime may be important for sovereign debt dynamics. First, country authorities may be better able to control nominal GDP, thereby providing a mechanism to stabilise debt-to-GDP without resorting to fiscal consolidation (including through a flexible exchange rate). Second, the central bank could have more flexibility to use seigniorage revenues to help repay debt (potentially at the expense of higher inflation). Third, large purchases of government debt (sterilised or unsterilised) could help to ‘coordinate’ creditors in order to avoid a run on sovereign debt, i.e. the central banks could reduce the likelihood of multiple equilibria.

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