Working Paper: CEPR ID: DP10315
Authors: Harris Dellas; Dirk Niepelt
Abstract: We shed light on the function, properties and optimal size of austerity using the standard sovereign model augmented to include incomplete information about credit risk. Austerity is defined as the shortfall of consumption from the level desired by a country and supported by its repayment capacity. We find that austerity serves as a tool for securing a more favorable loan package; that it is associated with over-investment even when investment does not create collateral; and that low risk borrowers may favour more to less severe austerity. These findings imply that the amount of fresh funds obtained by a sovereign is not a reliable measure of austerity suffered; and that austerity may actually be associated with higher growth. Our analysis accommodates costly signalling for gaining credibility and also assigns a novel role to spending multipliers in the determination of optimal austerity.
Keywords: austerity; credit rationing; default; growth; incomplete information; investment; pooling equilibrium; separating equilibrium
JEL Codes: F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| austerity (E65) | better loan terms (G51) |
| austerity (E65) | economic growth (O49) |
| low-risk borrowers (G21) | favor more severe austerity (E65) |
| overinvestment (G31) | costly signal to creditors (G32) |
| austerity (E65) | investment (G31) |
| higher austerity (E65) | higher welfare for creditworthy borrowers (G51) |
| austerity (E65) | non-monotonic relationship with growth (O42) |
| severity of austerity (E65) | ambiguous relationship with economic growth (O49) |