Sidestepping the Sovereign Debt Trap? The Case of Poland

We show that a sovereign debt trap can be sustained – even long term – provided economic growth that would be, if there was no sovereign debt, sufficiently high both in absolute terms and relative to fiscal deficit. While sustainable, the trap may still be as costly (or even more) as fiscal crises, as suggested by the case of Italy and Japan. We also show, based on data for Poland, how easy it is to fall into the trap. In particular, even a transitory slowdown may permanently raise the debt-to-GDP ratio. This might be the case even for government bond yields permanently lower than nominal GDP growth and forgoing some primary spending. The risk that Poland will fall into the trap is compounded by a projected permanent slowdown, circumvention of fiscal rules (if continued), and small corporate and financial sectors limiting the government’s ability to increase taxes without further dampening economic growth. As measures to cut that risk, we argue for growth enhancing reforms and strengthening fiscal rules. The latter would counteract the “war of attrition” and resolve the time inconsistency of a balanced budget policy, which we analyze by modifying the Barro–Gordon model.