Series: Working Papers. 2029.
Author: Pablo Burriel, Cristina Checherita-Westphal, Pascal Jacquinot, Matthias Schön and Nikolai Stähler.
Topics: Economic growth and convergence | Government debt | Quantitative methods | International Economy | Fiscal policy.
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Abstract
The paper reviews the economic risks associated with regimes of high public debt through
DSGE model simulations. The large public debt build-up following the 2009 global
financial and economic crisis acted as a shock absorber for output, while in the recent
and more severe COVID19-crisis, an increase in public debt is even more justified given
the nature of the crisis. Yet, once the crisis is over and the recovery firmly sets in, keeping
debt at high levels over the medium term is a source of vulnerability in itself. Moreover,
in the euro area, where monetary policy focuses on the area-wide aggregate, countries
with high levels of indebtedness are poorly equipped to withstand future asymmetric
shocks. Using three large scale DSGE models, the simulation results suggest that highdebt
economies (1) can lose more output in a crisis, (2) may spend more time at the zerolower
bound, (3) are more heavily affected by spillover effects, (4) face a crowding out of
private debt in the short and long run, (5) have less scope for counter-cyclical fiscal policy
and (6) are adversely affected in terms of potential (long-term) output, with a significant
impairment in case of large sovereign risk premia reaction and use of most distortionary
type of taxation to finance the additional debt burden in the future. Going forward, reforms
at national level, together with currently planned reforms at the EU level, need to be
timely implemented to ensure both risk reduction and risk sharing and to enable high debt
economies address their vulnerabilities.