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Limits to government debt sustainability in OECD countries

Jean-Marc Fournier and Falilou Fall

Economic Modelling, 2017, vol. 66, issue C, 30-41

Abstract: The recent euro area sovereign debt crisis has shown the importance of market reactions for the sustainability of debt in advanced economies. This paper calculates endogenous government debt limits given the markets assessment of the probability to default. The estimated primary balance reaction function to growing debt has the “fiscal fatigue” property (a loosening fiscal effort makes the primary balance insufficient to support rising debt) at high debt levels. The combination of this feature of the primary balance reaction function with the market interest rate reaction to growing debt determines the government debt limit beyond which debt cannot be rolled over. An application to OECD countries over the period 1985 – 2013 with a model-based risk-premium shows that current debt limits are high for most of the OECD thanks to particularly low risk-free interest rates. It also shows for some countries that current debt levels are not sustainable without a change in government behaviour. Most importantly, the framework illustrates the state contingent nature of debt limits and therefore the vulnerability of governments to a change in macroeconomic conditions and to market reactions. Last, computations with an estimated interest rate reaction to public debt illustrate that debt limits are lower in the euro area than in other countries because of a sharper market interest rate reaction to rising debt.

Keywords: Debt; sustainability; Fiscal policy; Primary balance (search for similar items in EconPapers)
JEL-codes: E27 E44 E61 E62 H62 H63 H68 (search for similar items in EconPapers)
Date: 2017
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