Working Paper: CEPR ID: DP17357
Authors: Fabrice Collard; Michel Habib; Ugo Panizza; Jean Charles Rochet
Abstract: This paper studies public debt sustainability under the assumption that a country always tries to service its debt obligations. We assume that default decreases the level of resources available for debt service, which consist of the country’s primary surplus and the proceeds from new debt issuance. We show that our model encompasses the well-known result that, as long as r < g, countries can permanently run small deficits. In our model, this result holds if there is no decrease in resource availability following default. We thus show that, in the presence of involuntary default, a lesser decrease in resource availability in default –a lower cost of default– increases maximum sustainable debt. This is the opposite of what it is normally found in models that assume limited commitment and strategic default. We calibrate our model using data for the Eurozone and find that many countries have actual debt levels that are higher than their maximum sustainable debt. In discussing possible reasons for these high observed debt levels, we emphasize the role of expected GDP growth, growth volatility, and resource availability. We also model the role of the European Stability Mechanism (ESM). We show that while the ESM can increase the level of maximum sustainable debt, it also crowds out private lending.
Keywords: sovereign debt; debt sustainability; default
JEL Codes: E62; F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reduction in resource availability due to default (G33) | constraints on future primary surpluses (H68) |
| reduction in resource availability due to default (G33) | constraints on new debt issuance (H63) |
| involuntary default (G33) | increase in maximum sustainable debt (H63) |
| maximum primary surplus, proceeds from new debt issuance, effects of default on these resources (H63) | maximum sustainable debt (H63) |
| risk-free interest rate exceeds growth rate (E43) | maximum sustainable debt is constrained (H63) |
| reforms aimed at reducing costs of default (G33) | more sustainable debt levels (H63) |