The limits of limitless debt

While low real interest rates and issuing public debt in fiat money safeguard against rising sovereign debt -to -GDP ratios, evidence shows that high debt often precedes default, and credit spreads may not signal imminent risk. We offer a simple way to model the trade-offs using local martingales. On the one hand, it acknowledges that large debt overhangs tend to raise default risks. On the other hand, it allows sovereigns to roll over debt regardless of long-term fiscal solvency. The combination allows credit spreads to stay very low for decades, eventually spiral out of control and trigger a default. Hence, neither the reassurance of low spreads nor the alarm from growing overhang should automatically prevail. To illustrate the trade-offs, we review the ebb and flow of US sovereign debt burdens since World War II. Between record peacetime debt -to -GDP ratios and weakened fiscal discipline, an exemplary double -or -triple-A credit rating for the US no longer seems justified. Moreover, the current outlook is poor, with debt growing much faster than GDP and scant prospects of contraction.

Automated summary

The article points out that low real interest rates and the issuance of public debt in fiat currency can prevent the ratio of sovereign debt to GDP from rising, but high levels of debt often precede default, and credit spreads may not signal an imminent risk. The article provides a simple way to model trade-offs using local martingales and reviews the ebb and flow of the US sovereign debt burden since World War II. Finally, it is pointed out that the US is no longer eligible for a model double A or triple A credit rating, and the current outlook is poor.