A Theory of Debt Accumulation and Deficit Cycles

81 Pages Posted: 14 Jul 2021

See all articles by Antonio Mele

Antonio Mele

University of Lugano; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: July 2021

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.

JEL Classification: E43, E44, E61, G01, G15, G38

Suggested Citation

Mele, Antonio, A Theory of Debt Accumulation and Deficit Cycles (July 2021). CEPR Discussion Paper No. DP16329, Available at SSRN: https://ssrn.com/abstract=3886815

Antonio Mele (Contact Author)

University of Lugano ( email )

Via Buffi 13
Lugano, 6900
Switzerland

HOME PAGE: http://antoniomele.org

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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