Growth-linked anti-cyclical debt: A solution for Europe’s public debt overhangs

European governments are overburdened with debt, yet Europe’s debt-centred financial markets lack a mechanism to efficiently reduce overhangs. In the private sector, household and corporate losses have left €1tn of non-performing loans on the balance sheets of banks, which have grown to 3.1 × GDP. In the public sector, despite the recent introduction of collective action clauses on sovereign bonds, the Greek example highlights still-limited flexibility to restructure sovereign debt. In this paper we analyse the impact of flexible debt that adjusts interest payments in line with growth performance: growth-linked anti-cyclical debt (GLAD). We model the economic impact of replacing nominal debt with growth-linked bonds for an economy subject to random external shocks as well as political cycles (eg pre-election excess spending). Our analysis shows GLAD bonds reduce the probability of austerity-debt spirals, by easing the burden of interest payments on economies hit by negative shocks, and smoothing cycles. GLAD bonds are naturally a more volatile instrument than normal fixed rate bonds, but they can be calibrated to give the same average payoff as a normal bond, ie compensating for the transfer of risk from creditors to debtors. In a currency union, where monetary policy is set based on the whole and therefore based mostly on large countries, GLAD bonds can provide an additional channel of flexibility for small countries.