Stochastic debt sustainability indicators

This paper proposes indicators to assess government debt sustainability in the medium and long term. We follow the methodological approach by Bohn (2008) and distinguish three channels that contribute to sustainable government finances: economic growth, real interest payments and fiscal responses. We combine the estimated fiscal response with a stochastic debt simulation to create two indicators. The first captures the probability of debt-to-GDP ratios rising by more than 20 percentage points during a 10-year period. A government will fail on this indicator if its fiscal response to an increase in debt is not sufficient to control the swings in debt caused by shocks to real growth and interest payments. The second indicator captures the probability of debt levels being above 90% of GDP in 10 years. We estimate these indicators using historical data for nine OECD countries. We find that the probability of debt-to-GDP ratios rising by more than 20 percentage points in the next decade clearly identifies countries that have sustainability concerns: Italy, Spain, Portugal and Iceland, from those that do not: US, UK, Netherlands, Belgium and Germany. JEL Classification: E4, E6, H0, H6