IMF economist Jonathan Ostri

Sounding the alarm on skyrocketing public debt: what happens if interest rates rise


Two IMF economists are concerned about the eye-popping debt level of most countries in the world, mainly due to the Covid-19 crisis and the risks it poses. Marcos Chamon and Jonathan Ostri, in their post titled “A Future with High Public Debt: Low-for-Long Is Not Low Forever” published on the Washington-based lender’s blog on April 20, warn of the possibility of a sudden increase in interest rates and urge countries around the world to plan fiscal programs from now on that will reduce their debt to sustainable levels in the future.

As the authors point out, since Covid-19 struck, the IMF has repeatedly called on governments around the world to generously increase their spending to support their economies, businesses and the most vulnerable sections of society, stressing the need for spending to be well targeted.

The European Central Banks’s position is similar, and governments, especially in developed economies, have accumulated massive amounts of debt in their efforts to deal with the economic impact of the Covid-19 crisis.

“But what should eventually be done about the high levels of public debt in the aftermath of this crisis?” Chamon and Ostry wonder.

According to the two economists, governments have been greatly facilitated by the low cost of borrowing. However, extensive lending has prompted warnings from the International Finance Institute about the rise of global public debt to unprecedented levels. It has also sparked controversy between economists and politicians, some of whom have called for part of the debt to be written off.

But will borrowing remain cheap for the entire horizon relevant for fiscal planning? Since that horizon seems to be the indefinite future, the answer here would be “no”, according to Chamon and Ostry.

IMF chart
The bar chart shows how much of the estimated fiscal space (debt limit minus 2007 debt) was used from 2007 to 2019 (blue bars), and how much is projected to be used from 2019 to 2025 (orange bars). Source IMF

“History gives numerous episodes of abrupt upticks in borrowing costs once market expectations shift. This risk is especially relevant for emerging market and developing economies where debt ratios are already high. At some point, debts may well need to be rolled over at higher rates” the two economists wrote.

And will it suffice to respond gradually to higher interest rates? Their answer again is “no.”

“Theory and history suggest that, when investors begin to worry that fiscal space may run out, they penalize countries quickly. Market-driven adjustments are not necessarily gradual, nor do markets only ratchet up the cost of borrowing once healthy growth returns—indeed, just the opposite seems plausible” they explain.

What’s the moral of the story?

“All countries will need to anchor fiscal plans with some notion of sustainability, which can also attenuate the concern of a market repricing of risk. This is not tomorrow’s worry if fiscal space is uncertain and market expectations can turn abruptly. Laying out plans to anchor expectations should be today’s worry for all” they conclude.

Jonathan D. Ostry is Deputy Director of the Asia and Pacific Department at the International Monetary Fund and a Research Fellow at the Center for Economic Policy Research (CEPR).  He is the author of a number of books on international macro policy issues and numerous articles in scholarly journals.

Marcos Chamon is a Deputy Division Chief in the Debt Policy Division of the Strategy and Policy Review Department of the International Monetary Fund. He was previously a Deputy Division Chief in the Research and in the Western Hemisphere Departments. Prior to joining the IMF, he obtained his Ph.D. in Economics from Harvard University in 2003.