Fiscal Policy, Sovereign Default, and Bailouts

35 Pages Posted: 21 Dec 2013

See all articles by Falko Juessen

Falko Juessen

University of Dortmund - Department of Economics; IZA Institute of Labor Economics

Andreas Schabert

University of Cologne - Department of Economics; University of Dortmund; University of Amsterdam - Faculty of Economics and Business

Abstract

This paper examines fiscal policy without commitment and the effects of conditional bailout loans. The government relies on distortionary taxation and decides between full debt repayment and costly default. It tends to overborrow due to myopia, which induces default to be a relevant policy option and provides a rationale to constrain sovereign borrowing. We consider a lump-sum financed fund that offers loans at a favorable price and conditional upon minimum primary surpluses. While the government prefers defaulting in the most adverse states, we find that it is willing to accept conditional loans in close-to-default states. These bailouts can lead to an increase in the mean debt price and a lower default probability that are associated with enhanced household welfare. Yet, these outcomes can be reversed when bailouts are too generous, while public debt never decreases in the long-run when bailout loans are available.

Keywords: discretionary fiscal policy, overborrowing, sovereign default, bailout loans, conditionality

JEL Classification: E32, H21, H63

Suggested Citation

Juessen, Falko and Schabert, Andreas, Fiscal Policy, Sovereign Default, and Bailouts. IZA Discussion Paper No. 7805. Available at SSRN: https://ssrn.com/abstract=2370771

Falko Juessen (Contact Author)

University of Dortmund - Department of Economics ( email )

D-44221 Dortmund
Germany

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Andreas Schabert

University of Cologne - Department of Economics ( email )

Cologne, 50923
Germany

University of Dortmund ( email )

Vogelpothsweg 87
Dortmund, 44227
Germany
+49 231 755 3288 (Phone)

University of Amsterdam - Faculty of Economics and Business ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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