Debt limits: 2025 edition

In recent decades, public debt has risen sharply and broadly, as we already discussed a year ago.1 Some of the countries that reached high peaks are now correcting course, but in other cases the levels remain high and there are no signs of them coming back down (see first chart). This has sparked occasional concern in financial markets, with investors becoming more sensitive to public finances.

Some of the advanced economies that are showing no signs of correcting their high levels of debts include the United States, France, the United Kingdom, Belgium and Japan. The growth outlook for nominal GDP, the government balance and interest rates suggest that, in the coming years, public debt ratios will continue to deteriorate significantly in the US, France and Belgium (see first table).2 In all three cases, the expected increase in debt reflects the outlook of sustained high primary government deficits (i.e. excluding interest payments).3 In addition, in the US the gap between interest rates and weaker economic growth will also make it difficult to reduce the debt. In contrast, in Japan, the gap between rates and growth is expected to facilitate the reduction of the country’s debt, while in the United Kingdom the debt ratio is likely to stabilise at current levels if the outlook for rates, growth and fiscal policy is met.

Reversing these trends will not be easy without substantial fiscal effort.4 Based on current GDP and interest rate forecasts, the US, France and Belgium will need to converge on an equilibrium primary fiscal balance at the very least if they are to begin reducing their debt ratios (see the last column of the first table). In the absence of changes to the path of fiscal policy, interest rates would need to fall sharply and/or nominal GDP growth would have to rebound strongly to stabilise and reduce debt (see the second and third tables). On the other hand, this does not mean that the sustainability of the debt is easily compromised by a rise in market interest rates. This is because rate increases in secondary markets are diluted by a relatively high average debt maturity (this mitigates the percentage of debt that is to be refinanced at a potentially higher cost). For example, given the current average debt maturities, we estimate that a sustained increase in secondary market interest rates of 100 bps would lead to an increase in the average cost of the debt, over an average horizon of 10 years, of around 25 bps across all the countries analysed overall (in the third year, the average impact would be around 15 bps, in the fifth year around 25 bps, and in the tenth year around 45 bps).

In contrast, the path followed by the euro area periphery and its growth and interest rate dynamics are, a priori, favourable for further reducing the debt ratios: as shown in the first table, in this scenario Italy, Spain and Portugal could achieve reductions of around 10 pps, 15 pps and 20 pps, respectively, in 10 years. Moreover, as seen in the second and third tables, the euro area periphery has a certain buffer that could allow it to withstand an increase in interest rates or a slowdown in GDP while still managing to reduce its debt ratios. However, these countries still face high debt levels, and making a deeper correction will require a significant fiscal effort, as the last table shows.5

Germany, for its part, is a special case. It currently has a low level of public debt, but projections for its GDP, rates and government balance point to a significant increase in its debt, led by investment and defence spending plans that have reoriented German fiscal policy in the last year.6

High debt is not necessarily a bad thing. Debt is a technology for storing wealth, managing crises, and investing in the future. The countries with the best credit capacity are those that can borrow the most. However, credit capacity can easily be eroded if the economy is unable to recover fiscal space when the economic environment is favourable. This is especially relevant after several years of strong nominal GDP growth and with the prospect of structural pressures on expenditure on the horizon (population ageing, defence and the energy transition).7