Over the past decade, economists such as Nobel laureate Paul Krugman have increasingly urged countries to embrace more government borrowing. But recent experience from the COVID-19 pandemic shows that too much debt can be a significant problem. New research shows that specifically during periods of crisis, nations with stretched finances will more than likely be penalized by financial markets and see their borrowing costs rise. The findings have significant implications for global policy.

“There is some part of the economics community that says it is fine to have debt,” says Darden Professor Davide Tomio, co-author of the new research. “But we think that there is a thing as too much debt.”

The Research: Costs of Borrowing and Economic Resilience

Tomio and other scholars found that fiscally constrained countries and U.S. states were more likely to see their costs of borrowing jump than those that were less indebted in early 2020. This phenomenon was true even when two countries had a similar level of COVID-19 infections.

“More fiscally sound countries appear to be more resilient to external growth shocks associated with the pandemic,” states the report titled “In Sickness and in Debt: The COVID-19 Impact on Sovereign Credit Risk.” In addition to Darden’s Tomio, the paper was written by Patrick Augustin, Valeri Sokolovski and Marti Subrahmanyam, from McGill University, HEC Montreal and NYU Stern School of Business, respectively.

The scholars focused their research on 30 developed countries in the Americas, Europe and the Asia-Pacific region, as well as 23 U.S. states. They deliberately chose developed nations to measure the direct effect of harsh economic restrictions, such as lockdowns, on borrowing costs. Lockdowns were more likely to be conducted in developed economies than in developing ones, Tomio explains.

The authors used data from the credit default swap (CDS) market to see how much the cost of borrowing changed for each state or country — CDS premiums frequently rise and fall as investors alter their views on the perceived risks of lending to individual countries or states. The research focused on the time between 1 January, when the World Health Organization activated its emergency response framework, and 18 May 2020, when a 500 billion euro European Union recovery fund was proposed.

The level of “fiscal capacity” with which each government could deal with an economic shock was measured using a slew of economic data, including credit ratings of the country or state, unemployment rates, GDP and levels of debt, as well as other relevant economic statistics. COVID-19 infection rates, population demographics and spending on health care were also analyzed.

The Results:  Fiscal Constraint vs. Wiggle Room

The broad findings showed that those countries that were more fiscally indebted saw increases in borrowing costs. That contrasted with the result for fiscally strong countries, which were “more resilient to the external growth shocks associated with the pandemic,” the report states. In other words, countries that had wiggle room in their budgets weren’t penalized with significantly higher borrowing costs in the market.

Perhaps surprisingly, the level of COVID-19 infections made little difference to the cost of borrowing for each entity unless the country or state was fiscally constrained. For the cash-strapped governments, there was a statistically significant relationship between increasing infections and subsequent jumps in the cost of borrowing, while for fiscally robust governments, the sensitivity of borrowing costs to COVID-19 infections was insignificant.

In a similar vein, the authors found that none of the apparent key health factors — such as the number of doctors, the number of hospital beds available, population density, or the portion of the population either elderly or obese — contributed to the changes in the cost of borrowing for countries or states. The research also found that differences in public health policy responses across the sample countries and states did not explain how borrowing costs changed during the crisis.

The authors were also able to eliminate monetary policy as a possible cause of different market reactions during the pandemic by studying countries and states that shared monetary policy. They confirmed the results by looking at countries in the eurozone, which meant they were all subject to identical monetary policy from the European Central Bank. Likewise, all of the U.S. states in the sample were subject to Federal Reserve monetary policy decisions. 

The Implications for Economists and Policymakers

The findings have clear implications for economists who believe that debt doesn’t matter and for policymakers seeking to bolster their countries or states against future economic stresses. The authors suggest that highly indebted governments would be wise to reduce their debts when they can or else risk facing higher borrowing costs at the very moment they need extra money. “Our finding that fiscal capacity amplifies the exposure of sovereign credit risk to systemic shocks underscores the need to … increase fiscal capacity in economically favorable times,” the report states.

Davide Tomio co-authored “In Sickness and in Debt: The COVID-19 Impact on Sovereign Credit Risk,” accepted for publication in the Journal of Financial Economics, with Patrick Augustin of McGill University, Valeri Sokolovski of HEC Montreal and Marti Subrahmanyam of the NYU Stern School of Business.


About the Expert

Davide Tomio

Assistant Professor of Business Administration

Tomio’s research focuses on market liquidity, derivative instruments and the consequences of central bank interventions. His recent work delved into the effects that the quantitative easing efforts by the European Central Bank have on the pricing, liquidity and availability of sovereign bonds. 

His work has been presented to, among others, the research and policy teams of the U.S. Federal Reserve Bank and Treasury Department, the European Central Bank, and the central banks of Germany, Canada and Italy, where he also taught. Tomio’s work has been cited by Forbes and published in the Journal of Financial Economics.

B.S., Ca’ Foscari University of Venice; M.S., University of Copenhagen; Ph.D., Copenhagen Business School