Deciding When Debt Becomes Unsafe
Source details
- Canonical URL
- Deciding When Debt Becomes Unsafe
Other formats
Bibliographic details
- Authors: Olivier Blanchard
- Published: March 1, 2022
Definition of "unsafe" debt
- 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."
- Determining safety requires projections and an assessment of the probability distribution of future outcomes, not a single point forecast.
Key determinants of debt dynamics
- The dynamics of the debt-to-GDP ratio 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: Form forecasts for the three determinants under existing policies and derive the implications for debt-to-GDP dynamics over the next decade or so.
- Produce distributions (ranges) for each variable to capture uncertainty.
- Assess risks such as:
- probability and magnitude of a recession;
- risk that real interest rates will rise and how debt maturity affects interest payments;
- distribution of the exchange rate if debt is partly in foreign currency;
- probability that implicit liabilities (for example, social security) become actual liabilities;
- distribution of the underlying potential growth rate.
- Step 2: Evaluate the likelihood that the government will change policy if adverse trajectories emerge.
- Considerations include:
- nature of the government (coalition vs. large majority);
- outcomes of future elections;
- country reputation and history of default.
- If, after Step 1, the probability that the debt ratio steadily increases at the end of the horizon is small enough, debt can be considered safe; otherwise Step 2 is required.
Uncertainty and the limits of simple rules
- There is no universal magic number for a safe debt level; context matters (country, time, policy, currency denomination, government type).
- Changes in real interest rates can materially alter safety assessments:
- Example: "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."
- Small changes in real rates can dramatically change debt-service costs: "An increase in the real rate from 1 percent to 2 percent will double the debt-service cost."
- The ratio of debt service to GDP can be a more relevant metric than debt-to-GDP, but it also faces substantial variability because real interest rates are uncertain.
Implications for policy and rules
- Simple fiscal rules (single debt or deficit thresholds) are inadequate because they cannot capture the many contingencies that affect debt sustainability.
- Strict rules (for example, Maastricht criteria or Black Zero balanced-budget norms), if enforced rigidly, will ensure sustainability but can constrain fiscal policy when relaxation is warranted.
- Historical example cited: fiscal consolidation in the European Union after the global financial crisis, triggered by rules, was "too strong and delayed the EU recovery."
- Complex rule-sets also fail in practice: adding conditions makes rules incomprehensible while still insufficient to address the underlying complexity.
Practical recommendation
- For meaningful assessments, apply the two-step approach to specific countries at specific times, using transparent assumptions and distributions, and then debate the reasonableness of those assumptions.
- Avoid seeking or applying one-size-fits-all simple or complex numeric rules; instead, use tailored probabilistic analysis that accounts for fiscal policy, interest-rate risk, growth uncertainty, debt structure, and political factors.
Source: Olivier Blanchard, "Deciding When Debt Becomes Unsafe," F&D Magazine, March 2022.
Content in this bundle
- وجهات نظر في الدين - متى يتقرر أن الدين أصبح غير آمن
- Deciding When Debt Becomes Unsafe
- Quand la dette devient-elle dangereuse ?
- 債務の見方
- Как узнать, когда долг становится небезопасным
- Cómo decidir cuándo la deuda se torna peligrosa ● Finanzas y Desarrollo ● Marzo de 2022
- 债务洞察