Sustainability of Public Debt: A Dangerous Obsession?

Abstract

Public debt sustainability has become a major concern since 2010. The Great Recession has indeed pushed public debt to historically high levels in peacetime. Doubts have been raised about the risk of insolvency for some governments in the euro area (notably Greece, Portugal, Ireland, Italy and Spain) triggering a rise in sovereign debt yields. Relying on indicators to gauge the ability of governments to meet their obligations is therefore crucial. Currently, the most widely used indicators to assess public debt sustainability are based on the intertemporal budget constraint of the government. The debt-dynamic relation provides an accounting view of sustainability, which is discussed in the first part of this chapter. It is emphasised that the construction of these indicators of sustainability critically hinges on hypotheses regarding the interest rate and the long-term growth. However, there is considerable uncertainty on these variables, as is stressed in the second part. On the one hand, interest rate on debt may be highly volatile in the short run, and governments may face a liquidity squeeze. During panics, it is hard to disentangle liquidity problems from solvency problems. On the other hand, a choice must be made about the GDP growth rate. It may be low in the short run in times of crisis, reducing sustainability, while it is subject to more uncertainty in the long run, depending on present and future policy changes. Moreover, it raises endogeneity issues, which are discussed in the third part. Consolidation is one option, but it may worsen debt sustainability if fiscal multipliers are high and if hysteresis effects of consolidation are significant. Assessing fiscal sustainability is therefore a tricky issue as the indicators used to assess it are fragile. Hence, policy-makers should not give too much importance to them. The fact remains that most European countries have to cope with high public debt and the risk of “unsustainability”. This may require alternative policy options. Monetary policy can play a role, and coordination between monetary policy and fiscal policy should be enhanced.