W

hen does the level of debt

become unsafe?
To answer this question, we need
a definition of “unsafe.” I propose
the following: 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.
The natural way to proceed is then straightforward.
The dynamics of the debt ratio depend on the
evolution of three variables: primary budget bal-
ances (that is, spending net of interest payments
minus revenues); the real interest rate (the nominal
rate minus the rate of inflation); and the real rate
of economic growth.

A two-step approach
The first step must be to form forecasts of those
three variables under existing policies and work out
the implications for the dynamics of the debt-to-
GDP ratio. Forecasts of these levels for the next
decade or so are likely to be available. But such
PERSPECTIVES ON DEBT forecasts are not enough; we need to assess the
uncertainty associated with those forecasts, which
means coming up with a range of possible outcomes

Deciding
for each variable.
That is much harder, and it involves answer-
ing some tricky questions. For example, what is
the risk of a recession and its likely magnitude?
What is the risk that real interest rates will rise?

When Debt
If they do, how does the maturity of the debt
affect interest payments?
If debt is partly in foreign currency—often the
case for emerging market economies—what is the

Becomes
likely distribution of the exchange rate? What is
the probability that some of the implicit liabilities
transform themselves into actual liabilities; that,
for example, the social security system runs a large

Unsafe
deficit which must be financed by a transfer from
the government? What is the distribution of the
underlying potential growth rate?
Going through this step delivers a distribu-
tion of the debt ratio, say, a decade from now. If
Don’t expect easy answers or simple rules. the probability that the ratio steadily increases at
Projecting growth, deficits, and interest rates the end of the horizon is small enough, we can
is just the beginning conclude that the debt is safe. If not, we must
ART: JOEL KIMMEL

move to the second step and answer the next set

Olivier Blanchard of questions: Will the government do something
about it? And if the government announces new

8 FINANCE & DEVELOPMENT | March 2022

 RETHINKING FISCAL

policies or commitments, what is the probability depends on the variability of real interest rates,
that it will deliver on those? which can be substantial. An increase in the real
This second step is even harder than the first. The rate from 1 percent to 2 percent will double the
answers depend on the nature of the government: debt-service cost. The cost may be low but it is also
a coalition government may be less likely to take uncertain, and the uncertainty will affect whether
tough measures than one with a large legislative the debt is safe or not.
majority. The outcome depends not just on the The long decrease in real interest rates is in
current government, but on those in the future, part what has triggered the current discussion
and thus the results of future elections. It depends on the appropriateness of magic numbers and
on the reputation of the country, and on whether, the reforms of EU budget rules. But the point
when, and why it has defaulted in the past. is much broader: take two countries with the
If all this sounds difficult, that’s because it is. same high debt ratio but with different types of
If it sounds like it depends on many assumptions governments, or debt denominated in different
that can be challenged, that’s because it does. This currencies. One’s debt might be safe, while the
is not a defect of the approach but a reflection other’s might not.
of the complexity of the world. But the exercise
must be done. Indeed, it is what credit-rating
agencies do, whether they use the same terms to
describe the process, and whether or not their The answer is not going to be
criterion for a less than perfect rating depends
on the same definition as mine. With a lower
rating comes the effective punishment; namely,
some universal magic number.
a government will have to compensate investors
for taking on the higher risk of default by paying So my answer to the question is, I do not know
a higher rate of interest. what level of debt, in general, is safe. Give me a
specific country and a specific time, and I will use
The problem with rules the approach above to give you my answer. Then we
Now let me go back to the original question. When can discuss whether my assumptions are reasonable.
does the level of debt become unsafe? But don’t ask me for a simple rule. Any simple
The process I have described makes it obvious that rule will be too simple. For sure, Maastricht criteria
the answer is not going to be some universal magic or so-called Black Zero (balanced budget) rules
number. Nor will there be a combination of two will, if they are respected, ensure sustainability.
magic numbers, one for debt and one for the deficit. But they will do so at the cost of constraining fiscal
This is particularly obvious if we think of changes policy when it should not be constrained. Most
in the underlying interest rates. Suppose, as has observers agree for example that fiscal consolidation
been the case in the United States since the early in the European Union in the wake of the global
1990s, that the real interest rate falls by 4 percent- financial crisis, a consolidation triggered by the
age points. That implies a decrease in the real cost rules, was too strong and delayed the EU recovery.
of servicing the debt of 4 percent of the debt ratio; And do not ask me for a complex rule. It will
so if debt is 100 percent of GDP, debt service falls never be complex enough. The history of the EU
by 4 percent of GDP. Quite obviously, lower rates rules, and the addition of more and more conditions
imply much more favorable debt dynamics. A debt to the point where the rules have become incom-
ratio that may have been unsafe in the early 1990s prehensible but are still considered inadequate,
ART: ISTOCK / LOGORILLA; AMOVITANIA

is much less likely to be unsafe now. We might proves the point.

conclude from this that the magic variable there-
fore should not be the ratio of debt to GDP, but OLIVIER BLANCHARD is the C. Fred Bergsten Senior Fellow
rather the ratio of debt service to GDP. This would at the Peterson Institute for International Economics. He
indeed be an improvement, but it comes with its previously served as economic counsellor and director of the
own problems: the variability of debt-service costs IMF’s Research Department.

March 2022 | FINANCE & DEVELOPMENT 9