Several historical examples show that financial crises generate large increases in private and public debt that take many years and sometimes drastic measures to resolve. The recent global financial crisis, which began in 2007, was no exception: The public debt of the affected countries increased to levels not seen for decades.
During a recession, tax revenue falls because of the contraction of GDP and governments also increase spending. The combination of these two forces increases deficits, and debt-to-GDP ratios can rise quickly as a result.
This mechanism can be seen very clearly in these scatter diagrams: Debt-to-GDP ratios (vertical axis) and deficit-to-GDP ratios (horizontal axis) are shown for the United States (red dots), Japan (blue dots), and the euro area (green dots) for several years after 2001. The changes in the two ratios are more marked for the recent financial crisis than what would be seen for plain vanilla recessions (such as the U.S. recession in 2001) that are not associated with such crises. As the recession ended, the deficit ratios started to decline because tax revenue grew and primary deficits (excluding interest) contracted. But the debt ratios kept rising, in part because primary balances are still negative and in part because the burden of interest is now larger.
How this graph was created: Search for and select the appropriate series for central government debt for each country and then add the appropriate series for the deficit-to-GDP ratio. Select “scatter” for the graph type in “settings.” The width of the lines connecting the dots can be adjusted in the settings of the first series.
Suggested by Silvio Contessi
