Impact on financial and economic stability
Elevated government indebtedness and delayed fiscal consolidation implies increased vulnerability of the financial system. In particular, large sovereign debt compromises governments’ capacity for supporting private balance sheets and stabilizing economic growth in future crises (view post here). Historically, such support has been critical for containing the mutually reinforcing dynamics of deleveraging and economic recessions. In the current highly leveraged global economy the fragility of such support weighs heavily.
Plausibly, high government debt ratios are also a risk for economic growth. Carmen Reinhart and Kenneth Rogoff popularized the view that high public debt, particularly above a threshold of 90% of GDP, has historically been followed by lower economic growth. Yet their empirical findings have failed to find broad support and a number of studies suggest that high debt, on its own, has not usually led to weaker activity (view post here).
However, there is evidence that high and rising public debt has often led to lower to softer growth. Also, on its own high government debt does often entail greater output volatility. (view post here). The broader point is probably that a sovereign’s financial vulnerability can easily team up with economic uncertainty, stoking fears about debt sustainability and precipitating negative economic and market momentum.
Finally, fiscal policy can have a powerful impact on inflation trends, in particular if monetary policy has to protect the sustainability of public finances. Since the global financial crisis and, particularly, the euro area sovereign debt crisis, central banks had to give greater consideration to public finance risk. The “fiscal theory of inflation” suggests that if monetary policy effectively protects public debt sustainability, fiscal easing is inflationary and fiscal tightening disinflationary or deflationary (view post here). In past years this mainly contributed to the risk of mutually reinforcing dynamics between deflation, debt problems and fiscal tightening. In the future, if fiscal policy should become expansionary again and monetary policy subservient to fiscal or political objectives this could lead to similarly reinforcing dynamics between fiscal expansion, rising inflation and a real erosion of debt stocks.