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Collateral, liquidity and debt sustainability

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  • Stefan Niemann
  • Paul Pichler

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Abstract

We study the sustainability of public debt in a closed production economy where a benevolent government chooses fiscal policies, including haircuts on its outstanding debt, in a discretionary manner. Government bonds are held by domestic agents to smooth consumption over time and because they provide collateral and liquidity services. We characterize a recursive equilibrium where public debt amounts to a sizeable fraction of output in steady state and is nevertheless fully serviced by the government. In a calibrated economy, steady state debt amounts to around 84% of output, the government's default threshold is at around 94% of output, and the haircut on outstanding debt at this threshold is around 40%. Both reputational costs of default and contemporaneous costs due to lost collateral and liquidity are essential to generate these empirically plausible predictions.

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Paper provided by University of Essex, Department of Economics in its series Economics Discussion Papers with number 730.

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Date of creation: 30 Aug 2013
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Handle: RePEc:esx:essedp:730

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