A Theory of Debt Accumulation and Deficit Cycles

Antonio Mele

No 16329, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper introduces a tractable model of sovereign debt where governments cannot default strategically, but face intertemporal tradeoffs between (i) preferring more primary deficits to less and (ii) avoiding costly defaults. Governments run deficits when debt and, then, the marginal costs of increasing debt are low. However, after an extended period of debt accumulation, default probabilities begin to rise quickly, and so do the marginal costs of running debt. Eventually, debt reaches a critical level relative to the size of the economy, a fiscal tipping point, after which debt accumulation stops, with governments cycling between deficits and surpluses, until perhaps a time of default. The main conclusions are that (i) fiscal tipping points typically occur when distance-to-default is between 10% and 20%; (ii) tipping points are pushed back in a stable macroeconomic environment, such that default premiums are higher in countries that implement austerity earlier and remain positive even when exogenous risk is very small (two "volatility paradoxes"); (iii) liquidity conditions and fiscal reforms may affect default probabilities in an ambiguous way; (iv) fiscal austerity may arrive too late: "debt intolerance" arises around the fiscal tipping point.

Keywords: Government debt; Default; Fiscal tipping points; Austerity; Deficit cycles; Volatility paradox (search for similar items in EconPapers)
JEL-codes: E43 E44 E61 G01 G15 G38 (search for similar items in EconPapers)
Date: 2021-07
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Working Paper: A Theory of Debt Accumulation and Deficit Cycles (2021)
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