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A Theory of Debt Accumulation and Deficit Cycles

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  • Antonio Mele

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

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 distanceto- 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.

Suggested Citation

  • Antonio Mele, 2021. "A Theory of Debt Accumulation and Deficit Cycles," Swiss Finance Institute Research Paper Series 21-38, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp2138
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    Keywords

    government debt; default; fiscal tipping points; austerity; deficit cycles; volatility paradox.;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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