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According to The Economist, lots of major economies are in debt to the extent of it consuming most of the countries' GDP. And the whole system almost seems to resemble a Ponzi scheme at a macro level. I'm sure this is a gross simplification of how things work and I'm no economist by any measure. But at some point, wouldn't the debt of these countries grow beyond the expectation that it will ever be paid off? How is it there is so much worldwide debt without the whole system ready to implode?

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Whether a country's debt is sustainable is a difficult question to answer. Bohn developped a framework for answering this question and the cited paper is a summary of much of its findings.

Henning Bohn, 2005. "The Sustainability of Fiscal Policy in the United States," CESifo Working Paper Series 1446, CESifo Group Munich.

Bohn proposes to estimate a fiscal reaction function to model a country's fiscal policy. He concludes that for a country's fiscal policy to be sustainable, it is sufficient that its primary balance is a (linear) increasing function of its lagged debt-GDP .

$pb_{it}= \alpha_i + \beta_i d_{it-1} + \delta_i X_{it} \ \ \ \ \ \beta_i>0$

($X_{it}$ is a vector of control variables)

There are however some problems with this framework. If for example does not exclude an ever increasing debt limit, which seems counter-intuitive. Some of these problems are resolved in Ghosh et. al. 2011 and non-linearities in a fiscal reaction function are added and they introduce the concept of fiscal space.

Atish R. Ghosh & Jun I. Kim & Enrique G. Mendoza & Jonathan D. Ostry & Mahvash S. Qureshi, 2011. "Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies," NBER Working Papers 16782, National Bureau of Economic Research, Inc.

Yet, there are still some drawbacks to this approach. Japan is a country that has almost reached its debt limit but financial markets doe no seem to response to this fact. Therefore this framework as evolved from estimating these fiscal reaction functions to stochastic debt simulation. Celasun, Debrun and Ostry wrote a seminal paper on this procedure.

Oya Celasun & Xavier Debrun & Jonathan David Ostry, 2006. "Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A "Fan-Chart" Approach," IMF Working Papers 06/67, International Monetary Fund.

They for example calculate the probability that a country's debt-GDP ratio increases more than 10% in comparison to a baseline-year. But again, this does not answer some fundamental questions. If for example the indebtedness of a country does increase with 10% in 5 years, does this mean that fiscal policy was insustainable?

It should be clear now that determining the sustainability of a country's debt is difficult. In the end, it really all comes down to the fact that a country's fiscal policy is sustainable as long as institutions and individuals are willing to buy their debt instruments.

edit: To answer your comment, I think the easiest concept to understand, it the one of fiscal space so I will try to explain that:

Assume a country's fiscal policy looks the following:

$pb_{t}= \alpha + \beta_1 d_{t-1}+ \beta_2 d_{t-1}^2 + \delta X_{it} $

In which $\beta_1>0>\beta_2$. This thus implies that a country's primary balance initially increases as debt increases to offset the debt accumulation but will decrease after a certain point, called fiscal fatigue. This fiscal fatigue implies a limit to the debt ratio a country could pay back. To see this, you have to look at the debt dynamics, (r-g) equals the interest rate-growth differential: $\Delta d_t= (r-g) d_{t-1} -pb_t$

This equation explains how an increase in primary balance could counter debt accumulation. The debt limit, lets call it $d^m$ is the highest debt ratio for which the primary balance sufficies to hold the debt ratio constant. ($X_t$ is ignored):

$(r-g) d^m = pb= \alpha + \beta_1 d^m + \beta_2 d^{m2}$

After $d^m$, the primary balance will never be high enough to hold debt constant due to fiscal fatigue. Lenders to the government know this and thus will never buy debt securities after this point, causing a country to default. Fiscal space is now simply the difference between a country's current debt ratio and the debt limit and thus is a measure of the amount of fiscal maneouvrability a country has left before it will default.

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  • $\begingroup$ Thanks for the detailed and well-cited answer! If I could upvote it, I would. It's a bit technical for me, being an outsider peering in. If you or any editors out there have the time to make it more friendly to newbies (i.e. pretend you're explaining this to your average child/teenager), I would greatly appreciate it! $\endgroup$ – jameslk Jan 2 '16 at 18:30
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    $\begingroup$ @jameslk Generally speaking, the idea is that it is equally preferred for the debt holder to pay off an entire debt in the present OR to pay exactly the interest rate for infinite periods, given that the interest rate reflects the time discount preference (of the gov't in this case). You prefer having some fraction of money now than a slightly larger sum later. So at some point, if you borrow so much that you can't pay off the interest under current policy, then debt becomes a problem (and you have to resort to nasty stuff like printing money or something). Otherwise, you're okay. $\endgroup$ – Kitsune Cavalry Jan 6 '16 at 3:51
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For any country that issues its own currency, having a sovereign debt in its own currency is a choice. It can always be monetised. This will cause a one-off inflation episode, but it does lessen, or entirely remove, the national debt.

So for all countries with sovereign debt in currencies they themselves issue, then no amount of national debt is theoretically unsustainable, in that it can always be monetised. The wider economic, political and social implications of that inflation episode will rather depend on the amount of debt being monetised, as well as the scope and scale of any other complementary measures introduced at the same time.

Furthermore, any country can pass a law cancelling its outstanding debt. Or it can negotiate a partial cancellation with its creditors. Either of these things will make it more expensive for that country to borrow in the future.

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The orthodox answer is that public debt spirals are never a problem, because a government can always issue new money to buy the debt off the market.

But this does not take into consideration how the private banking system works. Say country X is suffocating from 1 trillion dollars in public debt. 1 trillion dollars is issued and used to buy the debt from secondary markets. Is that the end of the story? No, because when the government adds 1 trillion in base money to the economy the banking system will use that new base money to create bank money (say M2) and the M2 will be traded for even more debt. The economy will have just traded public debt for private debt.

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    $\begingroup$ What do you mean by '...and the M2 will be traded for even more debt'. Even more debt for who? $\endgroup$ – dwjohnston Jan 6 '16 at 0:50

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