The Limits of Limitless Debt

How worrisome are mounting sovereign debt-to-GDP ratios? Many economists profess little concern. Debt stocks are irrelevant to sustainability in standard macro models, while low real interest rates testify to lender optimism. Furthermore, the debt is mostly in fiat currency, which eases rollover. Yet historical evidence (Reinhart and Rogoff, 2009) shows that high sovereign debt is prone to default and that credit spreads are often trailing indicators. This paper offers a simple way to model the trade-offs. 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 yet eventually spiral out of control and trigger 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 seem justified.