## Steady Prices, Sustainable Debt

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**Canonical URL:** [Steady Prices, Sustainable Debt](https://www.imf.org/-/media/files/publications/fandd/article/2022/march/reis.pdf)

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### Overview
- Public debt has risen steadily since 2000 with sudden spikes after the financial crisis in 2008 and at the beginning of the pandemic in 2020.
- The United States federal government has not run a fiscal surplus since 2001.
- U.S. public debt stands at $30 trillion, equivalent to about 130 percent of GDP, the highest since records began in 1791.
- The two-decade period of low and stable inflation coincided with central bank independence, explicit inflation-targeting mandates, and interest-rate-focused operational strategies.
- The central theme: preserving price stability is crucial to sustaining high public debt without triggering fiscal crises or undermining central bank independence.

### The "specialness" of public debt
- Governments sustain debt either by running future primary surpluses or by borrowing at rates below private-sector discount rates, creating a form of "debt revenue."
- Debt revenue arises when governments borrow at interest rates lower than the returns investors expect from private investment; this gap functions like a profit for the government.
- The "specialness" varies across countries:
  - Advanced economies (especially the United States) pay much less on public debt than emerging market economies.
  - Countries with strong reputations and institutions have been able to sustain larger debt increases.
- Global r-star (equilibrium real interest rate) has been falling for at least two decades due to:
  - Demographic transition to older populations increasing savings,
  - Productivity slowdown reducing demand for capital,
  - Higher inequality and financial risk leading households to save more and firms to invest less.
- These secular forces have helped both advanced and emerging economies sustain higher debt; sudden reversals would affect both government interest rates and government revenues.

### Five sustainability channels through which monetary policy affected debt revenue
- 1) Inflation and monetization temptation
  - Using inflation or monetization (printing currency) can lower real debt payments.
  - Central bank independence over the past two decades constrained this route, protecting public debt from inflation risk.
  - Risk: after national emergencies, finance ministries sometimes take over central bank functions.

- 2) Inattention capital and anchored expectations
  - Years of stable ~2 percent inflation built "inattention capital": households and firms stopped closely tracking price movements.
  - This anchored expectations contributed to lower nominal interest rates and followed the downward trend of the r-star.
  - The 2021–22 inflation spike signaled a break in this inattention; rising expected inflation would translate into higher interest rates on government debt.
  - If households start expecting higher future inflation (evidence emerging in summer 2021 for the United States), lenders will demand compensation for currency value loss.

- 3) Inflation risk premia on bondholders
  - Low and stable inflation removed inflation risk premia, maximizing debt revenue for governments.
  - If inflation and government rates fluctuate, Treasury interest expenses will fluctuate, and absent fiscal buffers, governments may need to raise distortionary taxes, raising overall investment risk.

- 4) Macroprudential policy and demand for safe assets
  - Post-financial crisis macroprudential measures increased demand for safe, liquid government bonds by requiring financial institutions to hold such assets.
  - Central banks lowering the chance of a financial crisis reduced expected fiscal bailout costs and supported higher public debt sustainability.
  - Risk: if fiscal crisis risk dominates, reliance on government bonds as system collateral can turn the bond market into the source of financial instability, blurring macroprudential policy and financial repression; central banks may then prop up bond demand, encouraging larger deficits and risking market collapse.

- 5) Quantitative easing (QE), central bank balance sheets, and maturity mismatch
  - QE replaced long-term government bonds held by the private sector with overnight bank deposits at central banks, shortening the maturity of public liabilities in private hands.
  - Historically, low and flat term structure made this low cost for central banks, but a policy response to inflation—raising short-term rates above long-term rates—would generate central bank losses.
  - Options to address those losses:
    - Print currency and collect seigniorage (likely to generate high inflation), or
    - Ask the Treasury to recapitalize the central bank, adding to the government deficit.
  - A sudden sell-off of government bonds to reverse this maturity shortening could itself trigger a crisis; therefore, states face tighter budget constraints if short-term rates must rise quickly.

### The case for price stability — findings and policy recommendations
- Findings
  - Price stability supports debt sustainability by:
    - Protecting public debt from inflation risk,
    - Anchoring inflation expectations,
    - Eliminating inflation-related risk premia,
    - Focusing macroprudential policy away from creating demand for government bonds as implicit fiscal support,
    - Guiding central bank balance sheet policy and fiscal backing decisions.
  - Surprising bondholders with unexpected inflation can transfer wealth to governments temporarily, but expectations adjust and the benefit is short-lived and risky.
  - Public debt sustainability that depends on surprising bondholders with inflation is unsound.

- Policy recommendations
  - Commit to price stability as the strategy that maximizes debt revenue and sustains public debt over many years.
  - Preserve and strengthen central bank independence rather than reduce it, even with high public debt.
  - Governments and central banks should reaffirm and strengthen commitments to explicit inflation targets.
  - Avoid relying on unexpected inflation as a tool to reduce real debt burdens; instead, maintain credible inflation control to keep borrowing costs low and stable.
  - Recognize that sustaining high public debt is a long-term task requiring credible monetary institutions and policies.

*Source: Ricardo Reis, "Steady Prices, Sustainable Debt", Finance & Development, March 2022.*

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