Although government debt in advanced economies has fallen since 2020, governments' fiscal space will begin to narrow again in the medium term due to rising interest rates and slowing economic growth, which will limit their ability to address future economic emergencies and potentially increase financial instability risks in more vulnerable countries like Italy. Fiscal deficits — which are the principal driver of changes in the debt-to-GDP ratio — peaked in 2020 at the height of the COVID-19 crisis. Since then, government debt-to-GDP ratios in advanced economies have declined. Average euro area debt fell from 79.4% of GDP to 76.6% between 2020 and 2022. The average amount of debt outstanding in G-7 countries (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States) also declined from 95.5% of GDP to 90.7% within the same time period, while U.S. government debt, in particular, declined from 99.1% of GDP to 94.7%. However, the debt-to-GDP ratios of France, Italy, Japan and Portugal continue to exceed 100% of GDP.

Post-COVID economic reopenings and a subsequent surge in nominal GDP growth have led to a sharp narrowing of fiscal deficits and a tangible decline in debt-to-GDP ratios in virtually all advanced economies. Following the severe economic contractions in 2020-21 due to the pandemic, the widespread resumption of business activity in 2022 led to a surge in both real economic growth and high inflation. Despite spending increases in many countries in 2022 aimed at supporting households from higher energy prices, fiscal deficits, measured as a share of GDP, have declined and government debt ratios have continued to fall due to high nominal GDP growth and a recovery in revenues. This has remained true even more recently in the context of slowing real GDP growth because of continued high inflation, which reduces debt-to-GDP ratios by reducing the real value of government debt. Increased government spending in 2022 has therefore not (yet) translated into larger nominal deficits. Nevertheless, fiscal deficits remain above 4% of GDP in many advanced economies — a somewhat arbitrary level that is generally too high to be consistent with medium-term debt sustainability.

• Advanced economies with high debt levels typically run fiscal deficits of more than 4% of GDP.
• Italy and Spain continue to be characterized by relatively high fiscal deficits, translating into high, but (for now) stable debt-to-GDP ratios of 147% and 112%, respectively. Europe's other former crisis countries — Greece and Portugal — are running much smaller fiscal deficits by comparison, which is translating into a rapid decline of their debt-to-GDP ratios and improving debt sustainability.

 
Declining debt-to-GDP ratios in the short term do not indicate improved medium-term debt sustainability because once growth dynamics and interest rates normalize, debt servicing costs and fiscal deficits will increase again. Nominal and real GDP growth will slow further in 2023 and nominal interest rates will continue to rise due to continued monetary tightening. Declining inflation and higher nominal interest rates will translate into higher government debt servicing costs. Slower economic growth (let alone recessions) will also adversely affect countries' fiscal and debt outlook — not least because central banks either have begun or will soon begin to sell off their government debt portfolio, further contributing to a rise in government financing costs. This is particularly problematic for advanced economies with high debt levels — namely, Belgium, France, Greece, Japan, Italy, Portugal, Spain and the United States, whose government debt all exceeded 100% of GDP in 2022. 

• According to the International Monetary Fund, Belgium, France, Greece, Japan, Italy, Portugal, Spain and the United States had government debt exceeding 100% of GDP last year. The IMF expects those same eight countries to exceed the 100% benchmark in 2025, too; however, in net debt terms, only France, Italy, Japan and the United States are forecast to have government debt exceeding their gross domestic product by then.

Governments' fiscal space and, in turn, their capacity to respond to future economic emergencies varies greatly among advanced economies. Fiscal space refers to the ability of a government to reduce revenues or increase expenditures without jeopardizing medium-term debt dynamics. A lack of fiscal space can also increase financial instability. Among the more indebted advanced economies, Italy remains by far the most vulnerable due to its particularly high debt-to-GDP ratio (which exceeds 140%), as well as its participation in the EU monetary union, which limits its access to emergency liquidity that a national central bank might provide. Compared with Italy, Belgium's debt is much smaller, which means that it has more fiscal room. Japan's debt is largely financed by domestic savers, and the Bank of Japan can also step into government bond markets to mitigate risks. The United States issues the world's dominant reserve currency (the dollar), providing it with an unmatched ability to finance itself. Greece's debt, while high, is falling rapidly. Greece's fiscal deficit is also much smaller than Italy's, and a large share of its debt benefits from below-market interest rates on account of official euro financial bailouts. 

Italy's particularly constrained fiscal space puts it at greater risk of financial destabilization than other advanced economies. The recent widening of Italian government bond yields is indicative of continued investor concerns. This does not mean that Italy will necessarily experience another sovereign crisis or large-scale financial stability. But among all of the advanced economies, it remains the country that is most at risk. Should future Italian governments fail to stick to conservative fiscal policies, especially in the context of the European Central Bank's quantitative tightening policy, investor concerns could quickly grow, increasing broader economic and financial risks in the euro area. This means that in a future financial emergency, Italy has more limited fiscal space to tackle it, less it risks broader financial instability if interest rates rise due to increasing investor concerns about debt sustainability.