## Deciding When Debt Becomes Unsafe

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**Canonical URL:** [Deciding When Debt Becomes Unsafe](https://www.imf.org/-/media/files/publications/fandd/article/2022/march/blanchard.pdf)

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### Definition and framework
- Debt becomes unsafe when "there is a non-negligible risk that, under existing and likely future policies, the ratio of debt to GDP will steadily increase, leading to default at some point."
- Debt dynamics depend on three variables:
  - primary budget balances (spending net of interest payments minus revenues);
  - the real interest rate (the nominal rate minus the rate of inflation);
  - the real rate of economic growth.

### Two-step analytical approach
- Step 1: Forecast the three variables under existing policies and derive implications for the debt-to-GDP ratio over the next decade or so.
  - Assess uncertainty by producing a range/distribution for each variable (possible outcomes).
  - Key uncertainty questions listed in the source:
    - What is the risk of a recession and its likely magnitude?
    - What is the risk that real interest rates will rise?
    - If they do, how does the maturity of the debt affect interest payments?
    - If debt is partly in foreign currency, what is the likely distribution of the exchange rate?
    - What is the probability that implicit liabilities transform into actual liabilities (for example, social security running a large deficit financed by government transfer)?
    - What is the distribution of the underlying potential growth rate?
  - The outcome of Step 1 is a distribution of the debt ratio, e.g., a decade from now; if the probability that the ratio steadily increases at the end of the horizon is small enough, the debt can be considered safe.
- Step 2: If risk is non-negligible, assess the probability the government will act and deliver on announced new policies or commitments.
  - This assessment depends on political economy factors:
    - nature of the government (coalition vs. large majority);
    - future governments and election outcomes;
    - country reputation and past defaults.
  - Step 2 is described as harder than Step 1 because it requires probabilistic judgment about policy responses and political constraints.

### Role of uncertainty and debt-service metrics
- The variability of real interest rates implies that focusing solely on the debt-to-GDP ratio is insufficient.
- The ratio of debt service to GDP is a potentially better variable, but it too is problematic because debt-service costs depend on the variability of real interest rates.
  - Example quantitative points:
    - "Suppose... the real interest rate falls by 4 percentage points. That implies a decrease in the real cost of servicing the debt of 4 percent of the debt ratio; so if debt is 100 percent of GDP, debt service falls by 4 percent of GDP."
    - "An increase in the real rate from 1 percent to 2 percent will double the debt-service cost."
- Lower real interest rates imply more favorable debt dynamics; a debt ratio that may have been unsafe in the early 1990s is much less likely to be unsafe now.

### On rules and "magic numbers"
- The answer to "what level of debt is safe" is not a universal magic number nor a simple pair of magic numbers (debt and deficit).
- Simple rules (e.g., Maastricht criteria or Black Zero balanced-budget rules) will ensure sustainability if respected, but:
  - They "will do so at the cost of constraining fiscal policy when it should not be constrained."
  - Example cited: "fiscal consolidation in the European Union in the wake of the global financial crisis, a consolidation triggered by the rules, was too strong and delayed the EU recovery."
- Complex rules will never be complex enough; history of EU rules shows additions of more conditions produced incomprehensible but still inadequate rules.

### Practical guidance and concluding points
- Do not expect easy answers or simple rules; the assessment must be country-specific and time-specific.
- The recommended exercise:
  - Produce forecasts and uncertainty distributions for primary balances, real interest rates, and real growth;
  - Evaluate the probability that debt dynamics imply rising debt ratios under current policies;
  - Assess the probability that governments will implement and succeed in required corrective policies.
- Final judgment requires explicit discussion of assumptions and their reasonableness.

*Source: Deciding When Debt Becomes Unsafe — Olivier Blanchard, Finance & Development, March 2022*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/march/blanchard.pdf_