Unsustainable Sovereign Debt - is the Euro Crisis only the Tip of the Iceberg?

Natasa Bilkic (), Ben Carreras Painter () and Thomas Gries
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Natasa Bilkic: University of Paderborn
Ben Carreras Painter: University of Paderborn

No 56, Working Papers CIE from Paderborn University, CIE Center for International Economics

Abstract: As a direct effect of the financial crisis in 2008, public debt began to accumulate rapidly, eventually leading to the European sovereign debt crisis. However, the dramatic increase in government debt is not only happening in European countries. All major G7 countries are experiencing similar developments. What are the implications of this kind of massive deficit and debt policy for the long term stability of these economies? Are there limits in debt-ratios that qualitatively change policy options? While theory can easily illustrate these limits, where are these limits in real economies? This paper examines the relationship between sovereign debt dynamics and capital formation, and accounts for the effects of the 2008 financial crisis on debt sustainability for the four largest advanced economies. We contribute to the literature on fiscal sustainability by framing the problem in an OLG model with government debt, physical capital, endogenous interest rates, and exogenous growth. For the calibration exercise we extract data from the OECD for Germany as a stabilization anchor in Europe, the U.S., the U.K., and Japan for almost two decades before the 2008 crisis. Except for intertemporal preferences all parameters are drawn or directly derived from the OECD database, or endogenously determined within the model. The results of the calibration exercise are alarming for all four countries under consideration. We identify debt ceilings that indicate a sustainable and unsustainable regime. For 2011, all four economies are either close to-, or have already passed the ceiling. The results call for a dramatic re-adjustment in budget policies for a consolidation period and long-term fiscal rules that make it possible to sustain sufficient capital intensity so that these economies can maintain their high income levels. Current conditions are already starting to restrict policy choices. However, the results also make it very clear that none of these economies would survive a second financial crisis such as the one in 2008.

Keywords: fiscal sustainability; primary deficit; debt ceiling; fiscal rules; OLG; calibration; advanced economies (search for similar items in EconPapers)
JEL-codes: E62 G01 H62 H63 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2012-09
New Economics Papers: this item is included in nep-mac
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Journal Article: Unsustainable sovereign debt—is the Euro crisis only the tip of the iceberg? (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:pdn:ciepap:56

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