Public debt burden and crisis severity

Abstract

Recent theoretical studies have highlighted that both the level of public debt and the unit cost of servicing the debt ($r-g$) play a role in the sustainability of public finances. This paper builds on this literature and introduces a new approach to analysing the relationship between economic downturns and sovereign debt risks by considering the total public debt burden, that is, the interaction between the level of debt and $r-g$. We conduct this analysis for 18 advanced economies over a span of 150 years, uncovering three novel findings. First, we document that the level of public debt and the interest-growth differential convey distinct information about public finances conditions, reinforcing the argument for incorporating both measures in the assessment of sovereign debt sustainability risks. Second, we offer a long-term historical perspective on the role of the total public debt burden in shaping the severity of recessions and the pace of subsequent recoveries. Our findings demonstrate that a high public debt burden is associated with deeper economic contractions, sharper declines in investment, deflationary pressures, and pronounced credit contractions during recessions. Further analysis of plausible transmission mechanisms suggests that an elevated total debt burden at the onset of recessions is linked to more limited accommodative policies during financial crises. Third, we document the feedback effects of financial crises on the components of the total public debt burden, demonstrating that both the level and cost of public debt systematically deteriorate, thereby heightening the risk of sovereign debt crises in the aftermath of financial turmoil.