EconPol Europe: Policymakers Should Consider High Public Debt Ratios as a Risk

High public debt ratios resulting from the Covid-19 crisis should be considered a potential source of problems, even in an environment of low interest rates. This is the key conclusion of a policy paper by Daniel Gros (EconPol, CEPS), which will be presented at EconPol’s annual conference. “A key but often overlooked legacy of the Covid-19 crisis is increased uncertainty,” Gros explains. In his paper, he points out that what makes increased uncertainty more important is that the cost of public debt goes up more than linearly with higher debt ratios.

There are two reasons why the post-Covid-19 environment should be considered more uncertain. First, a change in business models of member states, e.g., away from energy-intensive industries and tourism, has made growth prospects more uncertain. “In Europe, the outlook for different countries has diverged considerably, especially among countries that specialize in tourism and have only a weak digital infrastructure,” Gros says. Second, extreme events occur much more often than one would expect from “normal” distribution. “This does not imply that another health crisis is around the corner, only that after the Covid-19 shock, policymakers should update their planning processes to reflect the probability of future large shocks,” Gros says.

In this context, there should be concern about the legacy of a very high level of public debt. In some countries, such as Italy or the US, it has increased relative to GDP by between 25 and 30 percentage points. Moreover, the levels reached by a number of countries (close to 160 percent of GDP for Italy, 130 percent of GDP for the US, 200 percent of GDP for Greece) are above those that would have been considered prudent a few years ago. In his analysis, Gros cautions countries with high debt ratios not to simply rely on low interest rates to make their (Covid-19) debt sustainable. Otherwise, the next “once in a lifetime” shock might come at an even higher cost. A prudent policy would therefore be to start reducing debt levels to pre-crisis levels as soon as the economy normalizes.