Rethinking the Domar (r—g) Condition: Its Application to Greece, Japan, and China

This paper proposes a modified fiscal sustainability condition that explicitly incorporates the demand for government bonds, an often-overlooked factor in traditional analyses, which focus mainly on supply-side dynamics, such as the Domar (r − g) condition comparing the interest rate to the economy's growth rate. This paper finds that public debt sustainability depends on the interest rate's sensitivity to changes in government bond supply and demand. Empirical evidence supports our model's predictions, particularly when examining the experiences of Greece, Japan, and China. This modified fiscal sustainability condition suggests that opening the capital market to non-resident investors is essential, together with the stability of the bond market. Such liberalization should be approached cautiously, taking into consideration the relative speed at which foreign investors may exit the market compared with domestic investors.