the future of public debt: prospects and

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The Future of Public Debt:Prospects and Implications

Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli *

2 February 2010

Conference Draft

* Cecchetti is Economic Adviser at the Bank for International Settlements (BIS) and Head of its Monetary andEconomic Department, Research Associate of the National Bureau of Economic Research, and ResearchFellow at the Centre for Economic Policy Research; Mohanty is Head of the Macroeconomic Analysis Unit atthe BIS, and Zampolli is Senior Economist at the BIS. This paper was prepared for the Reserve Bank ofIndias International Research Conference Challenges to Central Banking in the context of Financial Crisis,Mumbai, India on 12-13 February 2010. We are grateful to Nathalie Carcenac, Jakub Demski, MagdalenaErdem and Gert Schnabel for the excellent statistical support. The views expressed in this paper are those ofthe authors and not necessarily those of the BIS.


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Cecchetti, Mohanty and Zampolli

1. Introduction

The financial crisis that erupted in mid-2008 led to an explosion of public debt in manyadvanced economies. Governments were forced to recapitalise banks, take over a large partof the debts of failing financial institutions, and introduce large stimulus programmes to revivedemand. According to the OECD, total industrialised country public sector debt is nowexpected to exceed 100% of GDP in 2010 something that has never happened before inpeacetime. 1 As bad as these fiscal problems may appear, relying solely on these officialfigures is almost certainly very misleading. Rapidly ageing populations present a number ofcountries with the prospect of enormous future costs that are not wholly recognised in currentbudget projections. The size of these future obligations is anybodys guess. As far as weknow, there is no definite and comprehensive account of the unfunded, contingent liabilitiesthat governments currently have accumulated.

Should we be concerned about high and sharply rising public debts? Several advancedeconomies have experienced higher levels of public debt than we see today. In the aftermathof World War II, for example, go vernment debts in excess of 100% of GDP were common. 2 And none of these led to default. 3 In more recent times, Japan has been living with a publicdebt ratio of over 150% without any adverse effect on its cost. So it is possible that investorswill continue to put strong faith in industria l countries ability to repay, and that worries aboutexcessive public debts are exaggerated. 4 Indeed, with only a few exceptions, during thecrisis, nominal government bond yields have fallen and remained low. So far, at least,investors have continued to view government bonds as relatively safe.

But bond traders are notoriously short-sighted, assuming they can get out before the stormhits: their time horizons are days or weeks, not years or decades. We take a longer and lessbenign view of current developments, arguing that the aftermath of the financial crisis ispoised to bring a simmering fiscal problem in industrial economies to boiling point. In the faceof rapidly ageing populations, for many countries the path of pre-crisis future revenues wasinsufficient to finance promised expenditure.

The politics of public debt vary by country. In some, seared by unpleasant experience, thereis a culture of frugality. In others, however, profligate official spending is commonplace. Inrecent years, consolidation has been successful on a number of occasions. But fiscalrestraint tends to deliver stable debt; rarely does it produce substantial reductions. And, mostcritically, swings from deficits to surpluses have tended to come along with either fallingnominal interest rates, rising real growth, or both. Today, interest rates are exceptionally lowand the growth outlook for advanced economies is modest at best. This leads us to concludethat the question is when markets will start putting pressure on governments, not if. When, inthe absence of fiscal actions, will investors start demanding a much higher compensation forthe risk of holding the increasingly large amounts of public debt that authorities are going toissue to finance their extravagant ways? In some countries, unstable debt dynamics, in which

1 Public finances in emerging market economies are generally in a much better shape. With their financialsystems and economies remaining relatively immune to the crisis, public debt levels have grown much lessrapidly, and are on average around 45% of GDP. One notable exception is India a country with a history offiscal problems where public debt remains high by todays emerging market standards.

2 In the United States, debt to GDP peaked at close to 121%, while in the United Kingdom it rose to about300%.

3 According to Reinhart and Rogoff (2008) Appendix Table 3, the last default in the industrial world was Japanand Germany in the immediate aftermath of World War II. There have been no advanced country defaults formore than half a century.

4 As a matter of macroeconomic theory, so long as the debt-to-income ratio is constant, an economy could livewith any level of debt.

The Future of Public Debt February 2010 1


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higher debt levels lead to higher interest rates, which then lead to even higher debt levels,are already clearly on the horizon.

It follows that the fiscal problems currently faced by industrial countries need to be tackledrelatively soon and resolutely. Failure to do so will complicate the task of central banks incontrolling inflation in the immediate future and might ultimately threaten the credibility of

present monetary policy arrangements.While fiscal problems need to be tackled soon, how to do that without seriously jeopardisingthe incipient economic recovery is the current key challenge for fiscal authorities. We believean important part of any fiscal consolidation programmes are measures to reduce futureliabilities such as an increase in the retirement age. 5 Announcements of changes in futureprogrammes would allow authorities to wait until the recovery from the crisis is assuredbefore reducing discretionary spending and improving the short-term fiscal position.

The remainder of this paper is organised into four sections. In section 2 we present anexamination of the recent build-up of public debt. Following the facts, we turn to a forward-looking examination of the public debt trajectories in industrial countries. In section 4 wediscuss the challenges these possible future debt levels pose to both fiscal and monetaryauthorities. The last section concludes.

2. The facts

After a large increase during the recent financial crisis and recession, public debt ratios areset to continue to rise over the next few years. How far depends on several factors: theultimate costs of the financial crisis, the rate of real growth and the level of interest rates, aswell as political decisions about spending and taxes. The fact that structural deficits have atendency to linger in industrial countries, together with large long-term age-related liabilities,makes the current policy in a number of countries unsustainable going forward. In this

section, we summarise the factors influencing long-term fiscal imbalances and then go on topresent projections of the path of debt-to-GDP ratios in large industrial countries.

Current and projected fiscal deficits

We start with Table 1. A key fact emerging from the table is that over the past three yearspublic debt has grown rapidly in countries where it had remained relatively low before thecrisis. This group of countries includes not only the United States and the United Kingdombut also Spain and Ireland. Although the rise in debt levels is comparatively small incountries with a history of debt problems (such as Italy and Greece), the crisis has,nevertheless, added fuel to their problems.

It is important to realise that, while the direct costs of financial crisis on governments mayappear large, they are in fact relatively small compared to indirect costs arising from lossesof tax revenues and increased expenditure to provide demand stimulus. Financial rescueprogrammes, including capital injection, treasury purchase of assets and lending as well asupfront government financing (but not debt guarantees), amount to 13.2% of GDP inadvanced economies so far (see IMF (2009)) and a significant part of this is likely to berecovered. 6

5 See Giavazzi (2009) for a discussion.6 This number is comparable with past crises. According to Laeven and Valencia (2008), in the previous 49

crises the average net direct resolution cost borne by the government has been 13% of GDP.



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Graph 1 Government gross public debt and primary fiscal balance in industrial economies 1, 2

As a percentage of GDP

20

40

60

80

100

120

140

8

6

4

2

0

2

4

71 76 81 86 91 96 01 06 11

Public debt (lhs)Primary balance (rhs)Structural primary balance (rhs)

Shaded areas represent forecast.1 Weighted average based on 2005 GDP and PPP exchange rates of economies cited and data availability. 2 Australia, Austria,Belgium, Canada, Denmark, France, Finland, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal,Spain, Sweden, Switzerland, the United Kingdom and the United States.

Sources: OECD; BIS calculations.

The permanent loss of potential output caused by the crisis also means that governmentrevenues may have to be permanently lower in many countries. Between 2007 and 2009, theratio of government revenue to GDP fell by 24 percentage points in Ireland, Spain, theUnited States and the United Kingdom. It is difficult to know how much of this will bereversed as the recovery progresses. Experience tells us that the longer households andfirms are unemployed and underemployed, as well a s the longer they are cut off from creditmarkets, the bigger the shadow economy becomes. 8

These concerns also need to be put into historical context. Many countries have a cleardeficit bias. To see this, note in Graph 1 the relationship between public debt and two majorindicators of the budgetary stance in advanced economies the primary balance (the deficitexcluding interest payments on the outstanding debt) and the structural primary balance (theprimary balance adjusted for cyclical increases in expenditure and cyclical decreases inrevenue). The graph shows that primary deficits in industrial countries have a life of theirown, staying high or low for a number of years running. Such persistence is clearly evident inthe 1970s and 1980s and again, to a lesser extent, in the early 2000s. To investigate thistendency, we perform a panel regression of the structural primary balance on its own lag, thelagged value of the debt stock and the contemporaneous value of the output gap, using thepast 30 years as a sample period. The estimates in Table 2 confirm that, on average, thestructural primary balance is highly persistent and, furthermore, allow us to conclude that itresponds positively to the lagged debt-to-GDP ratio. Taking the results at face value, weestimate the implied long-term response of the structural primary surpluses to a 1 percentagepoint increase in the debt-to-GDP ratio to be approximately 9 basis points. So, while thestance of fiscal policy does seem to adjust to an increase in the public debt level, theresponse is small. Furthermore, we find no evidence that that fiscal authorities behaveopportunistically, taking advantage of improvements in the output gap to tighten the stance offiscal policy. Taken together, all this suggests to us that fiscal policy is likely to remain highly

8 There is some evidence to suggest that VAT non-compliance among firms tends to worsen during aneconomic downturn; see Brondolo (2009). Schneider ((2009), for instance, predicts that the share of theshadow economy in OECD countries could rise, on average, by 0.5 percentage points of GDP in 2009 overthe previous year, reversing a declining trend since the early 2000s.



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expansionary in the near term. In addition, if past behaviour is any guide to the future, fiscalauthorities might find it difficult to adjust quickly unless, that is, they are left with no choice.

Table 2

Structural primary balance regressed on a constant, lagged debt-to-GDP ratio, laggedstructural primary balance and contemporaneous output gap 1

R2 Constant Debt-GDPratio (-1)Structural primary

balance (-1) Output gap

Panel estimation 2 0.76 -1.20*** 0.02*** 0.77*** 0.05



*, **, *** denote coefficients significantly different from zero at the 10%, 5% and 1% level, respectively.1 Sample period is 19702008. Countries in the sample: Austria, Australia, Belgium, Canada, Denmark, Finland, France,Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, New Zealand, Portugal, Spain, Switzerland, Sweden,United Kingdom, United States. 2 The panel regression has been estimated by OLS with White cross-section standarderrors and fixed effects. 3 The panel regression has been estimated by GMM with White cross-section standard errors andfixed effects (using as the instruments regressors and lags of dependent variable (from -1 to -3). 4 The panel regressionhas been estimated by GMM with White cross-section standard errors (using as the instruments regressors and lags ofdependent variable (from -1 to -3).Sources: OECD, Economic Outlook ; BIS estimates.

Long-term fiscal imbalances

More worryingly, the current expansionary fiscal policy has coincided with rising, and largelyunfunded, age-related spending. Driven by the countries demographic profiles, the ratio ofold-age population to working-age population is projected to rise sharply. Interestingly, this

rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are alreadyladen with relatively high debts (left-hand panel of Graph 2). Added to population ageing isthe problem posed by rising health care costs.

This leads us to the obvious conclusion that any assessment of the government fiscalsituation based on a short-term perspective is incomplete and at best misleading. A keyquestion is to what extent such accrued liabilities should be reflected in debt estimates.Concerns about both fiscal sustainability and intergenerational equity demand that theaccumulated net discounted value of all future revenues and expenditure commitmentsscheduled in current laws for the infinite time should be added to the current debt stock.Currently, however, there is no unique source providing such estimates. And uncertaintyabout future policy, demography and productivity growth make them unreliable.

That said, existing studies report that the magnitude of the long-term fiscal imbalance thepresent value of unfunded liabilities arising from ageing is very large. Huaner, Leigh andSkaarup (2007) estimate the change in the primary balance required to equate the netpresent discounted value of all future revenues and non-interest expenditures to the debtlevels prevailing at the end of 2005 for seven major industrial countries (Canada, France,Germany, Italy, Japan, the United Kingdom and the United States). The authors report that inorder for these countries to pay off all their financial liabilities, they would require an averageimprovement in their budget balance excluding interest payments of 4.5% of GDP. For theUnited States and Japan, the estimate is 6.9% and 6.2%, respectively. Other estimates aresimilar in magnitude. For example, Gokhales (2009) estimates for 23 industrial countriessuggest that the United States and major European countries would be required to generatean annual present value surplus of the order of 810% of 2005 GDP over the period to 2050.And the US Congressional Budget Office (CBO (2009)) projections are that in order to meetits age-related spending liabilities the United States would need a permanent improvement in



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its budget balances of the order of 2.6% of 2009 GDP in the next 50 years and 3.2% in 75years.

Graph 2

Projected population structure and age-related spending

Old-age population (ratio to working-age population) 1 Estimated increase in age-related governmentexpenditure from 2011 to 2050 2

0.0

0.2

0.4

0.6

0.8

1970 1980 1990 2000 2010 2020 2030 2040 2050

USJapanUKGermany

FranceItalySpainGreece

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15

US Jap an U K Ger ma ny Fran ce Italy Sp ain G reece

1 Working-age population is ages 1564. 2 As a percentage point of GDP.

Sources: IMF, WEO April 2007; United Nations Secretariat; European Commission; US Congressional Budget Office.

Because of the large uncertainties involved, we do not attempt to make our own projectionsof age-related liabilities, but instead rely on recent projections of age-related expenditure bythe European Commission and the CBO. The right-hand panel of Graph 2 reports theincremental age-related outlays between 2011 and 2050 estimated by these two agenciesunder their current baseline projection. We note that these numbers suggest that thedistribution of age-related spending is uneven across countries, with the burden considerablyhigher in Germany, Greece, Spain, the United Kingdom and the United States than in othercountries. At the level projected, US health care expenditures as a percentage of GDP would

double from about 5% today to 10% by 2035 and more than treble to 17% by 2080.

Interest rate and growth rate

The differential between the real interest rate and real output growth is a critical inputparameter in determining the future evolution of public debt. 9 When this differential is negative,so that the interest rate is below the growth rate, the debt ratio is bounded. By contrast, when itis positive, the debt ratio will explode in the absence of a sufficiently large primary surplus.

So far the build-up of public debt in industrial countries has taken place against the backdropof an exceedingly low interest rate environment. Despite low inflation, the real interest rate (ineffective terms) at which governments are able to finance their deficits and roll overoutstanding debt obligations has been falling since the late 1990s, reaching almost zero insome countries in the wake of the monetary policy response to the financial crisis (left-handpanel of Graph 3). However, as the graph reveals, the situation is changing quickly evenwithout a change in monetary policy-controlled interest rates. Real borrowing rates rosethrough 2009, and are poised to continue increasing with the reversal of the current zerointerest rate policy. Added to this is the fact that the crisis is likely to reduce the potentialoutput growth rate for some time to come (see Cecchetti and Zhu (2009)).

9The appendix contains a brief primer on the arithmetic of debt dynamics and the rationale behind ourprojections.



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Graph 3

Government borrowing and interest rate differentialsIn per cent

Real government borrowing rates 1 Interest rate differential and debt

6

3

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9

12

91 93 95 97 99 01 03 05 07 09

United StatesUnited Kingdom

GermanyItaly

SpainGreece

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AT BE

DK

FRFI

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JPNL

NZ

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2 1 0 1 2 3Real interest rate minus potential growth 3

P r i m a r y s u r p

l u s /

d e

b t

2

1 Effective real interest rate on public debt computed from government gross interest payments at period (t) divided by governmentgross financial liabilities at period (t-1) minus inflation rate. 2 Government primary surplus at period (t) divided by government grossfinancial liabilities at period (t-1) in 2009. 3 Effective real interest rate on public debt (average 1998-2007), minus OECD-estimated realpotential growth for 2012-2017.

Sources: OECD; BIS calculations.

The right-hand panel of Graph 3 is indicative of the severity of the problems that governmentsface. It plots a measure of the difference between the real interest rate and real growth on thehorizontal axis and the ratio of the primary surplus to total debt on the vertical axis. The higherthe differential between the real interest rate and potential output growth, the larger therequired structural primary surplus as a proportion of the previous-period debt level needed tomaintain a stable debt-to-GDP ratio. Turning to the graph, for debt-to-GDP to remain stable, acountry must be above the 45 degree line on the graph (which appears relatively flat due to thedifferences in the horizontal and vertical scale). The data show that the current fiscal policy isunsustainable in every country in the graph. Drastic improvements in the structural primarybalance will be necessary to prevent debt ratios from exploding in future.

3. The future public debt trajectory

We now turn to a set of 30-year projections for the path of the debt-to-GDP ratio in a dozenmajor industrial economies (Austria, France, Germany, Greece, Ireland, Italy, Japan, theNetherlands, Portugal, Spain, the United Kingdom and the United States). We choose a 20-year horizon with a view to capturing the large unfunded liabilities stemming from future age-related expenditure without making overly strong assumptions about the future path of fiscalpolicy (which is unlikely to be constant). In our baseline case, we assume that government

total revenue and non-age related primary spending remain a constant percentage of GDP atthe 2011 level as projected by the OECD. Using the CBO and European Commissionprojections for age-related spending, we then proceed to generate a path for total primarygovernment spending and the primary balance over the next 30 years. 10 Throughout theprojection period, the real interest rate that determines the cost of funding is assumed toremain constant at its 19982007 average, and real potential growth is set to the OECD-estimated post-crisis rate.

10 Note that the European Commission provides projections for age-related expenditure between 2008 and

2060. Using these projections we interpolated an annual series for age-related expenditure for the next 30years.



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Graph 4

Public debt-to-GDP projections

Austria France Germany

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80 90 00 10 20 30 40 0

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80 90 00 10 20 30 40

Baselinescenario

Small gradualadjustmentSmall gradualadjustmentwith age-relatedspending heldconstant

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80 90 00 10 20 30 40

Greece Ireland Italy

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80 90 00 10 20 30 40 0

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80 90 00 10 20 30 400

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80 90 00 10 20 30 40

Japan Netherlands Portugal

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80 90 00 10 20 30 40 0

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80 90 00 10 20 30 400

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Spain United Kingdom United States

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80 90 00 10 20 30 40

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80 90 00 10 20 30 400

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80 90 00 10 20 30 40

Sources: Authors projections.



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Debt projections

From this exercise, we are able to come to a number of conclusions. First, under ourbaseline scenario, conventionally computed deficits will rise precipitously. Unless the stanceof fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit-to-GDPratio will rise to 13% in Ireland; 810% in Japan, Spain, the United Kingdom and the United

States; and 37% in Austria, Belgium, Germany, Greece, the Netherlands and Portugal. Onlyin Italy do these policy settings keep the primary deficits relatively well contained aconsequence of the fact that the country entered the crisis with a nearly balanced budget anddid not implement any real stimulus over the past several years.

But the main point of this exercise is the impact that this will have on debt. The results plottedas the red line in Graph 4 show that in the baseline scenario, debt-to-GDP ratios rise rapidlyin the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear fromthe slope of the line, without a change in policy, the path is unstable. This is confirmed by theprojected interest rate paths, again under our baseline scenario. Graph 5 shows the fractionabsorbed by interest payments in each of these countries. From around 5% today, these

numbers rise to over 10% in all cases, and as high as 30% in the United Kingdom.Graph 5

Projected interest payments as a fraction of GDP

In per cent

0

5

10

15

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2015 2020 2025 2030 2035 2040

AustriaBelgiumFinlandFranceGermanyGreece

Ireland

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2015 2020 2025 2030 2035 2040

ItalyJapanthe NetherlandsSpainUnited KingdomUnited States

Source: Authors projections.

Seeing that the status quo is untenable, countries are embarking on fiscal consolidationplans. In the United States the aim is to bring the total federal budget deficit down from 11%to 4% of GDP by 2015. In the United Kingdom, the consolidation plan envisages reducingbudget deficits by 1.3 percentage points of GDP each year from 2010 to 2013.

To examine the long-run implications of a gradual fiscal adjustment similar to the ones beingproposed, we project the debt ratio assuming that the primary balance improves by1 percentage point of GDP in each year for five years starting in 2012. The results arepresented as the green line in Graph 4. Although such an adjustment path would slow therate of debt accumulation compared to our baseline scenario, it would leave several majorindustrial economies with substantial debt ratios in the next decade. This suggests thatconsolidations along the lines currently being discussed will not be sufficient to ensure debtlevels remain within reasonable bounds over the next several decades.

An alternative to traditional spending cuts and revenue increases is to change the promisesthat are as yet unmet. Here, that means embarking on the politically treacherous task ofcutting future age-related liabilities. With this possibility in mind, we construct a third scenario

that combines gradual fiscal improvement with a freezing of age-related spending-to-GDP atthe projected level for 2011. The blue line in Graph 4 shows the consequences of thisdraconian policy. Given its severity, the result is no surprise: what was a rising debt-to-GDP



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ratio reverses course and starts heading down in Austria, Germany and the Netherlands. Inseveral others, the policy yields a significant slowdown in debt accumulation. Interestingly, inFrance, Ireland, the United Kin gd om and the United States even this policy is not sufficient tobring rising debt under control. 11

Table 3Required average primary balance

to stabilise public debt-to-GDP ratio at 2007 level 1

over 5 years over 10 years over 20 yearsAustria 4.7 2.6 1.6France 7.3 4.3 2.8Germany 5.5 3.5 2.4Greece 5.4 2.8 1.5Ireland 11.8 5.4 2.2Italy 5.1 3.4 2.5Japan 10.1 6.4 4.5Netherlands 6.7 3.7 2.3Portugal 2.2 -0.3 -1.6Spain 6.1 2.9 1.3United Kingdom 10.6 5.8 3.5United States 8.1 4.3 2.41 As a percentage of GDP.Sources: IMF, World Economic Outlook ; OECD, Economic Outlook; authors calculations.

All of this leads us to ask: What level of primary balance would be required to bring the debt-to-GDP ratio in each country back to its pre-crisis, 2007, level? Granted that countries thatstarted with low levels of debt may never need to come back to this point, the question is aninteresting one nevertheless. Table 3 presents the required average primary surplus target tobring debt ratios down to their 2007 levels over horizons of five, 10 and 20 years. Anaggressive adjustment path to achieve this objective within five years would mean generatingan average annual primary surplus of 810% of GDP in the United States, Japan, the UnitedKingdom and Ireland, and 57% in a number of other countries. While a preference tosmooth the adjustment over a longer horizon reduces the annual surplus target, it is unlikelyto lead to a major improvement over the current situation.

Risks from fiscal imbalances

The future profile of public debt presents major risks and challenges for both fiscal andmonetary policy. Here we focus on the real implications of living with a higher level of debt,and turn to challenges facing monetary authorities in the next section.

When a country starts from an already high level of public debt, it raises the probability that agiven shock will trigger unstable debt dynamics. Knowing this, we would expect investors todemand a higher risk premium for holding the bonds issued by a highly indebted country.Studies of the impact of debt on risk premia are rather limited for advanced economies. Whatevidence there is suggests that the impact is relatively small. For each percentage point of

11 Such a policy path is unlikely to reduce Japans debt ratio substantially because of only a small increase inprojected age-related spending in future.



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Last but not least, the existence of a higher level of public debt is likely to reduce both thesize and the effectiveness of any future fiscal response to an adverse shock. Since policycannot play its stabilising role, a more indebted economy will be more volatile. This wasevident during the latest crisis. Countries saddled with very high levels of public debt did notexpand fiscal policy as much as other countries. And, although these countries benefitedsomewhat from the effects of foreign fiscal expansion, a larger domestic fiscal stimulus couldhave helped to reduce the severity of the recession actually experienced.

Graph 6

Sovereign CDS spreads 1 and fiscal indicators 2

General government debt/GDP 3 General government revenue/GDP 3

AU

ATBECA

DK FRFI

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JP

NLNZ

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SECHGB

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35 40 45 50 55

Share of short-term debt 4 Change in general government debt/savings 5

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15 30 45 60 75 901 Vertical axis: average spread over the last 20 working days; in basis points. 2 Horizontal axis. 3 Forecast for 2011. 4 Domesticgovernment debt with a remaining maturity of one to three years as a percentage of total domestic government debt. 5 Averagechange in general government debt as a percentage of average private savings; forecast average for the period 200911.

Sources: IMF; OECD; JPMorgan Chase; Markit.

4. The challenge for central banks

Steeply rising public debt levels and the uncertainty associated with future fiscalconsolidation plans pose at least two important challenges for monetary policymakers. First,deteriorating public finances can trigger a sudden increase in long-term inflationexpectations. Second, uncertainty about the timing and extent of fiscal consolidation planscomplicates the forecasting needed to set policy interest rates at their appropriate level. Inthe following, we focus on the inflation risks.



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Is there currently a risk that inflation expectations may rise? And what can monetarypolicymakers do to reduce this risk? To answer these questions, it is helpful to review themechanisms by which persistently high fiscal deficits could lead to inflation. 17

A first mechanism stresses the ultimate impossibility of continuing to roll over ever increasinglevels of public debt when monetary and fiscal authorities are pursuing inconsistent

objectives. When the public reaches its limit and is no longer willing to hold public debt, thegovernment would have to resort to monetisation. The result, consistent with the quantitytheory of money, is inflation. And anticipation that this will happen would lead to an increasein inflation today as investors reassess the risk from holding government bonds. In such anenvironment, fighting rising inflation by tightening monetary policy would not work, as anincrease in interest rates would lead to higher interest payments on public debt, leading tohigher debt, bringing the likely time of monetisation even closer. 18 Thus, in the absence offiscal tightening, monetary policy may ultimately become impotent to control inflation,regardless of the fighting credentials of the central bank.

Conflicts between the goals of fiscal and monetary authorities can explain a number ofinflationary outbursts in emerging market economies. Notable examples of this include the

Brazilian inflationary boom in the early 1980s when monetary policy, in the face of persistentfiscal deficits, started to act more aggressively against inflation (Loyo (1999)); the large jumpin Israeli inflation in October 1983 (Sargent and Zeira (2008)); and the Indian inflation of the1970s and 1980s in which fiscal deficits were monetised (Rangarajan and Mohanty (1997)).

Graph 7

Inflation expectations

In per cent

Break-even inflation rates (five-year, five-year-ahead) Mid-term inflation expectations (ten-year-ahead) 1

0

1

2

3

4

5

2000 2002 2004 2006 2008

United States

Euro area

0

1

2

3

4

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91 93 95 97 99 01 03 05 07 09

United States: Euro area: Japan:

ConsensusSPF ConsensusSPF Consen-sus

1 For Survey of Professional Forecasters (SPF): euro area, five-year-ahead.

Sources: Federal Reserve Bank of Philadelphia; Consensus Economics; Survey of Professional Forecasters; national data; BIS

calculations.

17 A main distinction in the literature is whether the quantitative theory of money holds (in which case inflation isalways and everywhere a monetary phenomenon) or whether fiscal variables have a direct influence on theprice level in addition to money (fiscal theory of the price level).

18 This is the finding of Sargent and Wallaces analysis (1981). Note that in their example debt is perfectlyindexed in real terms. This rules out the case that inflation arises from the monetary authorities attempt toreduce its real value. Inflation, instead, arises because at a certain point bond investors refuse to hold debtand the government is therefore forced to issue money, short of an outright default.



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A second mechanism by which public debt can lead to inflation focuses on the political andeconomic pressures that a monetary policymaker may face to inflate away the real value ofdebt. The payoff to doing this rises the bigger the debt, the longer its average maturity, thelarger the fraction denominated in domestic currency, and the bigger the fraction held byforeigners. And incentives to tolerate temporarily high inflation rise if policymakers see asocial benefit to helping households and firms to reduce their leverage in real terms. It isworth emphasising that the costs of creating an unexpected inflation would almost surely bevery large in the form of permanently high future real interest rates.

While discussions of inflation risks in the financial press abound, there is little evidence thatfiscal prospects are materially affecting inflation expectations. While United States and euroarea market-based inflation expectations became volatile immediately before and after therecent financial crisis, Graph 7 shows that they have reverted to the average levels of thepast five years or so. Meanwhile, survey-based measures of inflation expectations in bothareas have been more stable than market-based ones.

Although the chance of a government being forced to monetise its debt is rather remote inthe short run, the chance that it could do so in the future is not insignificant. 19 Therefore, the

risk that long-term inflation expectations could suddenly become unanchored today is apossibility that should not be discounted. The most likely manifestation of this risk is anunexpected and abrupt rise in government bond yields at medium and long maturities asnegative news about the state of the economy and public finances leads investors toreassess the risks of fiscal unsustainability and future inflation.

5. Conclusion

Our examination of the future of public debt leads us to several important conclusions. First,fiscal problems facing industrial economies are bigger than suggested by official debt figures

that show the implications of the financial crisis on fiscal balances. As frightening as it is toconsider public debt increasing to more than 100% of GDP, an even greater danger arisesfrom a rapidly ageing population. The related unfunded liabilities are large and growing, andshould be a central part of todays long-term fiscal planning.

It is essential that governments not be lulled into complacency by the ease with which theyhave financed their deficits thus far. In the aftermath of the financial crisis, the path of futureoutput is likely to be permanently below where we thought it would be just several years ago.As a result, government revenues will be lower and expenditures higher, makingconsolidation even more difficult. But, unless action is taken to place fiscal policy on asustainable footing, these costs could easily rise sharply and suddenly.

Our second finding is that large public debts have significant financial and real

consequences. The recent sharp rise in risk premia on long-term bonds issued by severalindustrial countries suggests that markets no longer consider sovereign debt low-risk. Thelimited evidence we have suggests default risk premia move up with debt levels and downwith the revenue share of GDP as well as the availability of private saving. Countries with arelatively weak fiscal system and a high degree of dependence on foreign investors tofinance their deficits generally face larger spreads on their debts. This market differentiation

19 History shows that countries that ran high public debts eventually ended up in high inflation becausegovernments were unwilling to pay high interest rates. Makinen and Woodward (1990) provide experience ofthe European countries during the interwar period. Following funding crises, governments in many countries(Belgium, Spain and Italy) pegged interest rates and resorted to debt monetisation. Germanys hyperinflationis also an important reminder of this risk.



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is a positive feature of the financial system, but it could force governments with weak fiscalsystems to return to fiscal rectitude sooner than they might like or hope.

Third, we note the risk that persistently high levels of public debt will drive down capitalaccumulation, productivity growth and long-term potential growth potential. Although we donot provide direct evidence on this, a recent study suggests that there may be non-linear

effects of public debt on growth, with adverse output effects tending rise as the debt-to-GDPratio approaches the 100% limit (Reinhart and Rogoff (2009b)).

Finally, looming long-term fiscal imbalances pose significant risk to the prospects for futuremonetary stability. We describe two channels through which unstable debt dynamics couldlead to higher inflation direct debt monetisation and the temptation to reduce the real valueof government debt through higher inflation. Given the current institutional setting ofmonetary policy, both risks are clearly limited, at least for now.



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Appendix: Budget accounting and debt dynamics

This appendix provides a summary of the main budget accounting identities that lie behindour discussion in the main text and that have been used to generate projections of futurepublic debt-to-GDP ratios under different scenarios.

Our starting point is the consolidated government sector budget identity :

(1) ,( ) ( 111 ++=+ t t t t t t t t H H D DT DiG )where G is the nominal level of primary government expenditure, and i is the nominal interestrate paid on nominal public debt D . The right-hand side indicates that total nominalexpenditure (the left-hand side) can be funded through taxes T , new debt issuance (thesecond term on the right-hand side) and the change in the stock of central bank liabilities ormonetary base (the third term on the right-hand side). The last term is also calledseigniorage. In economies in which long-term inflation is low and stable as it has been inmajor advanced economies since at least the mid-1980s this source of public finance hasbeen relatively small.

Dividing through by nominal GDP and rearranging terms, (1) can be rewritten as:

(2) t t t t t t sd r d d ++= 11

( )( ) t t t t t t

t gigi

r ++

+

1

11

1

t t t t g

where now the small letters represent ratios of the original variables to GDP. According to(2), the change in the public debt-to-GDP ratio depends on real interest payments (adjustedfor real output growth), the primary deficit and seigniorage s (all expressed as a share ofGDP). If the real interest rate on debt is larger than real output growth, then the debt-to-GDPratio increases, even if a government manages to match its primary expenditure withrevenue. In this case, new debt needs to be issued simply to cover the interest payments onthe outstanding stock of debt. 20 As new debt is added, interest payments will increase evenfurther, thus leading to the issuance of ever greater amounts of debt. Roughly speaking,when a government indefinitely issues new debt to pay interest on the stock of debt (andany additional non-funded expenditure) it is said to be running a Ponzi scheme, and its debtis set to grow without limit. (Below, this statement will be made more precise).

However, a country does not have an unlimited capacity to borrow. The best way to see thisis to solve (2) forward and rewrite it as an intertemporal budget constraint. For simplicity, weassume that both the nominal interest rate and nominal income growth are constant overtime (so that we can drop the time subscript from them). We obtain:

(3)( ) ( ) 10 11 1

lim1

+

+

=+

++

+

++

+=

j jt

j j

j jt jt

t r

d

r

sd

20 Ignoring seigniorage, it follows from (2) that the condition for the debt-to-GDP ratio to remain constant overtime is that:(*)

t t t r d 1 = ; or (after simple manipulation): t t t r D 1 =

that is, the primary surplus scaled by debt need be identical to the difference between the real return on publicdebt and real output growth. Relation (*) is plotted as a 45-degree line on the right-hand panel of Graph 3. If acountrys primary surplus lies below such a line, then it will experience an increase in its debt-to-GDP ratio,and vice versa. How far a country is from the line provides a visual representation of how fast its debt-to-GDPratio will increase at a given point in time.



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cut public expenses without causing major social and political disruptions) and the responseof financial markets to the state of the economy and the state of public finances.

Other approaches look at the magnitude of primary surpluses that a government needs toproduce over time for its debt ratio to be stabilised at current levels or at some (lower orhigher) level at some point in the future. An advantage of this approach is that it is to some

degree less arbitrary than other approaches mentioned above, as the amount ofassumptions and information required as an input are kept to a minimum. In this paper, weadopt this simpler approach. Specifically, we use (2) to project debt-to-GDP ratios into thefuture under different scenarios concerning the profile of primary surpluses. To keep thingssimple, we also assume that in (2) the real interest rate and real output growth are timeinvariant. And we also assume that seigniorage remains zero throughout. Such anassumption is justified by the fact that in advanced economies with low inflation seigniorageis rather small.



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