Reducing Government Debt Ratios in an Era of Low Growth

Almost a decade after the onset of the global crisis, government debt-to-GDP ratios in the advanced economies have stabilized well above their precrisis levels. Living with high debt is living dangerously: When government debt is large, an increase in interest rates causes a sizable rise in the cost of debt service and therefore in the risk of financial crisis brought about by an interest rate–debt spiral. Reducing high debt ratios poses a daunting challenge, because the range of options for reducing debt is more limited than it once was and economic growth in the next decade is expected to be lower—as a result of population aging and the lingering effects of the crisis—than it was before the global crisis. Declines in the long-run economic growth rate drive increases in the government debt-to-GDP ratios and lead to fiscal crises, including defaults. Past studies have underestimated—in tone, if not necessarily in substance—the role of economic growth in determining the path of debt ratios. This Policy Brief proposes an extended accounting approach that fully recognizes the importance of economic growth in this regard, by keeping track of the impact of growth on the primary fiscal surplus. It concludes that a gradual but sustained fiscal adjustment through expenditure cuts and revenue increases is the most appropriate means of reducing the chances of debt crisis in the coming decade.