Playing with fire (and national debt)

Fun ways to play with fire … It may take a few bps prediction error on how deficits affect GDP growth for the markets to take off on a “diabolic” spread-debt loop. The graph below contains my simulations, taken from a working paper of mine (“A Theory of Debt Accumulation and Deficit Cycles”).

Define the spread curve as the relation between the debt-to-GDP ratio of a country and the spread over a riskless security that the markets require to invest in the national debt issued by that country. The blue curve is the spread curve in an economy with low growth. The red curves are the spread curves in an economy with more deficits; the solid line results when a higher deficit improves economic growth; the dashed line results in the unlucky circumstance where more deficits are not followed by more growth. With a debt-to-GDP ratio at about 130%, a reform that goes the wrong way might rapidly lead a country to spiral to default.

Does not mean that deficits lead to default. Means that when debt is high compared to GDP, extreme caution would need to be exercised while deciding upon the nature and extent of a deficit (if any).

Keywords: Spread; parameter uncertainty; fiscal reforms; default.