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The Limits of Limitless Debt

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How worrisome are mounting sovereign debt-to-GDP ratios? Many economists profess little concern. Debt stocks are irrelevant to sustainability in standard macro models, while low real interest rates testify to lender optimism. Furthermore, the debt is mostly in fiat currency, which eases rollover. Yet historical evidence (Reinhart and Rogoff, 2009) shows that high sovereign debt is prone to default and that credit spreads are often trailing indicators. This paper offers a simple way to model the trade-offs. On the one hand, it acknowledges that large debt overhangs tend to raise default risks. On the other hand, it allows sovereigns to roll over debt regardless of long-term fiscal solvency. The combination allows credit spreads to stay very low for decades yet eventually spiral out of control and trigger default. Hence, neither the reassurance of low spreads nor the alarm from growing overhang should automatically prevail. To illustrate the trade-offs, we review the ebb and flow of US sovereign debt burdens since World War II. Between record peacetime debt-to-GDP ratios and weakened fiscal discipline, an exemplary double-or-triple-A credit rating for the US no longer seem justified.

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  • Kent Osband Valerio Filoso & Capasso Salvatore & Valerio Filoso, 2022. "The Limits of Limitless Debt," CSEF Working Papers 662, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    • Handle: RePEc:sef:csefwp:662
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    More about this item

    Keywords

    bond market; bond interest rate; credit spreads; sovereign debt; sovereign debt default; debt management surprise;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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