High public debt amplifies fiscal risks via liquidity channel
A new Banque de France working paper shows that high public debt amplifies the deterioration of fiscal sustainability after fiscal expansions. The study uses a heterogeneous-agent model to demonstrate how weakened precautionary bond demand requires higher-for-longer real interest rates.
The self-insurance channel of debt
Researchers Cristiano Cantore, Matteo Gatto, Francesco Saverio Gaudio, and Pascal Meichtry examine how initial public indebtedness shapes policy shock transmission using a New Keynesian model with three household types.
When households rely on government bonds for self-insurance against idiosyncratic risk, high public debt reduces the marginal insurance benefit of newly issued bonds.
This weakens precautionary demand and lowers the liquidity premium—the expected return spread between illiquid capital and liquid bonds.
To induce households to absorb additional debt, the central bank must maintain real interest rates higher for longer, raising debt-servicing costs and compressing fiscal space.
Monetary transmission remains invariant
By contrast, the transmission of monetary policy shocks is largely independent of the initial debt-to-GDP ratio.
Expansionary monetary policy lowers real interest rates, stimulates activity, and reduces debt-servicing costs uniformly across debt levels.
Because monetary shocks have a limited impact on the insurance value of government bonds, the self-insurance motive is muted.
Consequently, initial debt levels do not meaningfully alter monetary policy effectiveness, unlike fiscal expansions.