Expansionary Fiscal Consolidation Under Sovereign Risk

This paper develops a sovereign default model with capital accumulation, long-term debt, and fiscal rules with two distortions: debt dilution and private underinvestment. Fiscal rules generate a long-run economic expansion because they mitigate default risk caused by dilution, which increases capital accumulation. In the short run, however, the economy goes through a costly transition where consumption and investment drop to finance debt reduction. These dynamic trade-offs are quantified, and the welfare gains of fiscal rules are computed using a calibration for Argentina. A debt limit of 44 percent of gross domestic product attains the maximal welfare gain of 0.5 percent. Implementation of the debt limit generates short-lived drops in consumption and investment of 5 and 7 percent, respectively, and a long-run gross domestic product expansion of 1.4 percent. The paper relaxes the assumption of commitment to the rule and discusses how the threat of exclusion from implementing future rules provides enough incentives to avoid deviations. Welfare gains more than double in this case.