Working Paper: CEPR ID: DP16687
Authors: Bernard Dumas; Paul Ehling; Chunyu Yang
Abstract: In a deterministic overlapping-generations economy with production and physical capital, the price of debt can be positive without any budget surpluses being in the offing, because debt incorporates a rational bubble. Yet the dynamics of debt remain a function of the dynamics of the primary budget deficit. As a way to study their joint behavior, we endogenize a structural deficit in the form of an underfunded social-security scheme. We define debt capacity as the level of debt that can be just sustained without a change of policy all the way to an unstable steady state. When it starts below the capacity, the debt converges to a stable steady state, in which the bubble is sustained. Above capacity the bubble unravels and the deficit cannot be financed. In several realistic scenarios occurring in economies, we calculate the needed policy response, which is the true "fiscal cost" of exceeding debt capacity.
Keywords: debt capacity; fiscal policy; asset market bubbles; social security; sustainability
JEL Codes: E13; E43; E44; E50; E62; E63; H30; H62; H63; H68
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| existence of a rational bubble (E32) | sustainability of debt (F34) |
| government debt exceeds a certain threshold (debt capacity) (H63) | unsustainable primary budget deficit (H68) |
| unsustainable primary budget deficit (H68) | unstable steady state (C62) |
| delayed responses to rising debt levels (H63) | larger fiscal adjustments (E62) |