Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

We develop a closed economy model to study the interactions among sovereign risk premia, fiscal limits, and fiscal policy. The stochastic fiscal limits, which measure the ability and willingness of the government to service its debt, arise endogenously from a dynamic Laffer curve. The distribution of fiscal limits is country-specific, depending on the size of the government, the degree of countercyclical policy responses, economic diversity, and political uncertainty, among other characteristics. The model rationalizes different sovereign ratings across developed countries. A nonlinear relationship between sovereign risk premia and the level of government debt, which emerges in equilibrium, is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. Movements in default risk premia for long-term bonds precede those for shortterm bonds, providing early warnings of increasing probabilities of sovereign defaults.Fiscal policy; International topics

Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

We develop a closed economy model in order to study the interactions among sovereign risk premia, fiscal limits and fiscal policy. The stochastic fiscal limit, which measures the ability and willingness of the government to service its debt, arises endogenously from dynamic Laffer Curves. The distribution of fiscal limits is countryspecific, depending on the size of the government, the degree of the counter-cyclical policy responses, economic diversity and political uncertainty, and, therefore, the model can rationalize different sovereign ratings across developed countries. The model also produces a nonlinear relationship between sovereign risk premia and the level of government debt. The nonlinearity is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. The default risk premia of long-term bonds jump ahead of short-term bonds and provide early warnings of sovereign defaults.

Sovereign default and monetary policy tradeoffs

The paper is organized around the following question: when the economy moves from a debt-GDP level where the probability of default is nil to a higher level—the “fiscal limit”—where the default probability is non-negligible, how do the effects of routine monetary operations designed to achieve macroeconomic stabilization change? We find that the specification of the monetary policy rule plays a critical role. Consider a central bank that targets the risky rate. When the economy is near its fiscal limit, a transitory monetary policy contraction leads to a sustained rise in inflation, even though monetary policy actively targets inflation and fiscal policy passively adjusts taxes to stabilize debt. If the central bank targets the riskfree rate, on the other hand, the same transitory monetary contraction keeps inflation under control but leads output to contract for a prolonged period of time. The comparison shows that sovereign default risk puts into sharp relief the tradeoff between inflation and output stabilization

Uncertain Fiscal Consolidations

The paper explores the macroeconomic consequences of fiscal consolidations whose timing and composition are uncertain. Drawing on the evidence in Alesina and Ardagna (2010), we emphasize whether or not the fiscal consolidation is driven by tax rises or expenditure cuts. We find that the composition of the fiscal consolidation, its duration, the monetary policy stance, the level of government debt and expectations over the likelihood and composition of fiscal consolidations all matter in determining the extent to which a given consolidation is expansionary and/or successful in stabilizing government debt.government debt, budget reform, monetary-fiscal policy interactions

Uncertain Fiscal Consolidations

The paper explores the macroeconomic consequences of fiscal consolidations whose timing and composition are uncertain. Drawing on the evidence in Alesina and Ardagna (2010), we emphasize whether or not the fiscal consolidation is driven by tax rises or expenditure cuts. We find that the composition of the fiscal consolidation, its duration, the monetary policy stance, the level of government debt and expectations over the likelihood and composition of fiscal consolidations all matter in determining the extent to which a given consolidation is expansionary and/or successful in stabilizing government debt.

Sovereign Debt Risk Premia and Fiscal Policy in Sweden

This paper takes a step toward providing a general equilibrium framework within which to study the nub of the current fiscal debate around the world: what are the tradeoffs between short-run stabilization and long-run sustainability when the perceived riskiness of government debt depends, in part, on the current and expected fiscal environment in place? We calibrate a simple model to Swedish fiscal data in two periods: before and after the financial crisis of the early 1990s. We compute the dynamic fiscal limit, which depends on the peak of the Laffer curve, for the pre-crisis and three alternative post-crisis fiscal policies. The model simulates the macroeconomic consequences of alternative policies in the face of the sequence of bad output shocks that Sweden experienced from 1991-1997.

Rapport till Finanspolitiska rådet 2010/3 Sovereign Debt Risk Premia and Fiscal Policy in Sweden

Finanspolitiska rådet är en myndighet som har till uppgift att göra en oberoende granskning av regeringens finanspolitik. Rådets uppgifter fullföljs framför allt genom publiceringen av rapporten Svensk finanspolitik som lämnas till regeringen en gång per år. Rapporten ska kunna användas som ett underlag bland annat för riksdagens granskning av regeringens politik. Som ett led i uppdraget anordnar rådet även konferenser och utger skrifter om olika aspekter på finanspolitiken. I serien Studier i finanspolitik publiceras fördjupade studier eller rapporter som härrör från externa uppdrag. Finanspolitiska rådet Abstract This paper takes a step toward providing a general equilibrium framework within which to study the nub of the current fiscal debate around the world: what are the tradeoffs between short-run stabilization and long-run sustainability when the perceived riskiness of government debt depends, in part, on the current and expected fiscal environment in place? We calibrate a simple model to Swedish fiscal data in two periods: before and after the financial crisis of the early 1990s. We compute the dynamic fiscal limit, which depends on the peak of the Laffer curve, for the pre-crisis and three alternative post-crisis fiscal policies. The model simulates the macroeconomic consequences of alternative policies in the face of the sequence of bad output shocks that Sweden experienced from 1991-1997

Uncertain fiscal consolidations

The paper explores the macroeconomic consequences of fiscal consolidations whose timing and composition are uncertain. Drawing on the evidence in Alesina and Ardagna (2010), we emphasize whether or not the fiscal consolidation is driven by tax rises or expenditure cuts. We find that the composition of the fiscal consolidation, its duration, the monetary policy stance, the level of government debt and expectations over the likelihood and composition of fiscal consolidations all matter in determining the extent to which a given consolidation is expansionary and/or successful in stabilizing government debt