Dangers Related to Public Indebtedness: The Sovereign Risk Channel

The paper analyzes the theoretical consequences of the sovereign risk channel for economic activity and other global macroeconomic variables. We show that public debt would have no recessionary consequences below 50% of GDP. However, if public debt rises from around 80% to 120% of GDP, the exponential increase in risk premiums on public bonds would raise interest rates across all credit and financial markets. This would imply recessionary consequences for economic activity and all macroeconomic variables. Finally, above this maximum public debt level (around 120% of GDP), public debt is already excessive, and further increases would have progressively diminishing effects on economic activity.