01 February 2023

CEPR: Assessing debt sustainability in the euro area

In the euro area, the COVID-19 pandemic led to a substantial increase in government debt. This column discusses a new approach to evaluate public debt sustainability in the euro area. Over the past ten years, the ECB has played a key role in stabilising the European sovereign debt market.

 However, the recent inflationary surge could be a game-changer because a strong reaction by the ECB and a rapid increase in real rates could spell trouble for a number of peripheral European economies.

The global financial crisis and the COVID-19 pandemic led to a rapid accumulation of public debt in both developing and advanced economies. In the euro area, debt increased by nearly 30 points of GDP over the period 2007-2021 (Figure 1).

 

In the aftermath of the European debt crisis of 2011-2012, the ECB played an important role in stabilising the market for European sovereign debt. With inflation well below target, the ECB did not face any obvious tradeoffs in this stabilisation role. However, things have changed rapidly. Euro area inflation peaked at 10.5% in October 2022 and remains four times above target.

If expectations remain anchored, this can be good news for debt sustainability because a short-lived burst of inflation that leads to negative real interest rates can help to reduce debt-to-GDP ratios (Reinhart and Kirkegaard 2012, Reinhart and Sbrancia 2015). As pointed out by Blanchard’s influential presidential address, as long as the interest rate on the public debt, r, is lower than GDP growth, g, countries can stabilise (or reduce) their debt ratios even in the presence of moderate primary deficits. There are, however, two issues with this argument. First, r < g does not seem to hold in most advanced economies (Wyplosz 2019). Second, the current inflationary environment could usher a new era marked by high real interest rates.

If inflation does not converge rapidly to target, central banks will need to keep tightening in order to maintain credibility and keep expectations well-anchored (Corsetti and Codogno 2022). In the presence of high debt levels, higher rates can lead to another debt crisis within the euro area (Lorenzoni et al. 2022). Given this high level of uncertainty, the need to develop analytical tools aimed at evaluating debt sustainability and assessing the role of different policies aimed at preventing destructive debt crises is more important than ever.

We contribute to the literature with a model that derives a simple formula for a country’s maximum sustainable debt under the assumption that countries always try to repay their debts but might be pushed into default because they lack the resources necessary to service existing debt (Collard et al. 2022). ¹  In our formula, the six main determinants of maximum sustainable debt are: expected growth, growth volatility, maximum primary surplus, the risk-free interest rate and its volatility, and the recovery rate in the immediate aftermath of default....

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