Threats of sovereign debt overhang in the EU, the new fiscal rules and the perils of policy drift

Abstract

After the Great Recession and the Covid Crisis the sovereign debt sustainability has again become a major public policy issue. Since the Great Recession Olivier Blanchard (2019) has put forward the theory of a “good and bad” debt equilibrium. The good debt equilibrium is usually supported by high economic growth rates, low risk premia, and lower interest rates, being sustainable and self-stabilizing. The bad debt equilibrium is driven by a self-fulfilling prophesy where higher risk premia, higher interest rates, and sovereign debt destabilize each, as also studied empirically by Paul De Grauwe (The Aust Econ Rev 45:255–68, 2012). Reconstructing those two equilibria and the threat of debt overhang for specific EU countries, we then: first explore possible escape routes from sovereign debt threats; second, evaluate the new EU fiscal rules that constrain the deficit spending to the growth rate of potential output; and third, evaluate the possible future EU policy drift endangering the new fiscal rules. Finally we stress the need for social buffers in the EU while intending to stabilize sovereign debt.