The End of Magical Debt Thinking

CAMBRIDGE – For over a decade, numerous economists – primarily but not exclusively on the left – have argued that the potential benefits of using debt to finance government spending far outweigh any associated costs. The notion that advanced economies could suffer from debt overhang was widely dismissed, and dissenting voices were often ridiculed. Even the International Monetary Fund, traditionally a stalwart advocate of fiscal prudence, began to support high levels of debt-financed stimulus.

The tide has turned over the past two years, as this type of magical thinking collided with the harsh realities of high inflation and the return to normal long-term real interest rates. A recent reassessment by three senior IMF economists underscores this remarkable shift. The authors project that the advanced economies’ average debt-to-income ratio will rise to 120% of GDP by 2028, owing to their declining long-term growth prospects. They also note that with elevated borrowing costs becoming the “new normal,” developed countries must “gradually and credibly rebuild fiscal buffers and ensure the sustainability of their sovereign debt.”

This balanced and measured assessment is far from alarmist. Yet, not too long ago, any suggestion of fiscal prudence was quickly dismissed as “austerity” by many on the left. For example, Adam Tooze’s 2018 book on the 2008-09 global financial crisis and its consequences uses the word 102 times.

Until very recently, in fact, the notion that a high public-debt burden could be problematic was almost taboo. Just this past August, Barry Eichengreen and Serkan Arslanalp presented an excellent paper on global debt at the annual gathering of central bankers in Jackson Hole, Wyoming, documenting the extraordinary levels of government debt accumulated in the aftermath of the global financial crisis and the COVID-19 pandemic. Curiously, however, the authors refrained from clearly explaining why this might pose a problem for advanced economies.

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