How concerns about public debt harm the private sector

How do worries about a country’s sovereign debt affect its real economy? The question is highly practical, with higher global public debt levels post-COVID and nations from Argentina to Zambia expected to struggle with upcoming bond payments.

Many economists have sought to understand the economic effects of a full-blown sovereign debt default. But less attention has been paid to the more common scenario of a country simply considered to be at risk of default. The issue poses an identification challenge: The same economic conditions that push a country to struggle with debt payments and undermine investor confidence can simultaneously affect the real economy of firms and workers.

In a recent Minneapolis Fed staff report, Monetary Advisor Cristina Arellano uses microdata covering the 2012 Italian sovereign debt crisis to determine how fears about Italy’s public debt harmed the private economy (Staff Report 547, “Sovereign Default Risk and Firm Heterogeneity” with Yan Bai and Luigi Bocola). Using firm-level balance sheet and bank industry data, the economists find sovereign debt risk was responsible for about one-third of the decline in Italy’s GDP from 2011 to 2013, making an already deep recession considerably worse.

The primary reason: As domestic banks holding a portfolio of sovereign debt see its price and value fall, they transmit the effects—through higher interest rates—to the firms that depend on them for credit.

The economists are among the first to apply micro-level data within a macroeconomic general equilibrium model of sovereign debt and default. They begin with data on the borrowing levels of every public and private Italian firm between 2007 and 2015. Crucially, they also obtain the branch locations and Italian government debt holdings of every Italian bank. This allows them to divide the country into regions that vary widely in the degree to which their banks are exposed to government debt.

Italian firms that depend on credit tend to borrow predominantly within their region. By comparing the performance of firms within and across these regional “islands,” Arellano and co-authors net out the different channels by which the falling price of Italian sovereign debt flows through to firms in the real economy.

Their model identifies a direct effect, by which banks transmit the falling value of their sovereign debt holdings to firms in the form of higher interest rates. And by comparing the performance of companies that do little-to-no borrowing across these differentially affected regions, the economists can also isolate the secondary, indirect effects of these tighter credit conditions (transmitted through prices and other economic forces).

Having calibrated their model with the microdata, the economists compare real-world economic outcomes to a counterfactual scenario in which Italy faces the same aggregate economic conditions—minus the concerns about a government default. They find that without sovereign debt risk, Italian output would have declined only 3.2 percent in 2012 versus the observed 6.4 percent. Every 100 basis-point increase in the interest rates of sovereign debt passes through a 64 basis-point increase in the interest rates faced by private firms. Sovereign debt risk appears responsible for 28 percent of private debt defaults by firms. Perhaps surprisingly, the indirect effects of sovereign risk are positive and appear to partly offset the negative direct effects, as firms cut their borrowing and operate more conservatively in the face of tighter general credit conditions.

All told, the research finds that spillovers from worries about Italy’s sovereign debt accounted for about one-third of the decline in Italy’s GDP during the debt and economic crisis of 2011 to 2013. The findings suggest that high levels of government debt can inflict significant harm on a struggling economy, even if—as in the case of Italy—the government never defaults.

Read the Minneapolis Fed staff report: Sovereign Default Risk and Firm Heterogeneity