06 May 2019

Public debt and the risk premium

A dangerous doom loop

Cinzia Alcidi / Daniel Gros

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The current environment of low to ‘ultra-low’ interest rates fosters the view that ‘deficits do not matter’. However, debt does matter. Countries with high debt levels often pay a risk premium. The combination of a high debt level with a high risk premium creates self-reinforcing loops. Italy represents a telling example of a negative loop whereby a high debt level, combined with increasing deficits, leads to a higher risk premium and hence higher refinancing costs. Portugal provides the opposite example. A moderate reduction in fiscal deficits has so much improved the outlook for future debt levels that the risk premium has fallen to less than one half of the Italian level, thus reducing the interest payment burden and debt. Low interest rates tempt high debt countries to accumulate further debt. This temptation should be resisted, as the true cost of debt is much higher than perceived.