A government, whose debt is denominated in its own currency, need never face default. In the event of insolvency, created by an unexpected spending need or revenue shortfall, the country can always restore solvency with seigniorage (Sargent and Wallace 1981) and/or debt devaluation through unexpected inflation. Monetary union eliminates these instruments unless the union is willing to sacrifice price stability to restore solvency for an individual country. The European Central Bank has a single mandate of price stability, and no explicit mandate for individual country fiscal solvency.
Founders of the European Monetary Union were concerned that fiscal insolvency could threaten the currency union. They sought to replace the loss of individual-country monetary policy instruments with more prudent fiscal policy by placing limits on debt and the deficit. However, the world-wide financial crisis and recession, which began in 2007 and accelerated in 2008, has had profoundly negative consequences for government budget deficits and debt, with almost all countries in violation of the limits. In 2009 and 2010, interest rates for some countries relative to German rates spiked, reflecting market concern that these countries might default on their debt. What does economic theory have to offer about market concerns that some EMU countries could default?
In traditional models of sovereign default, a sovereign defaults when benefits to default exceed costs, typically modeled either as exclusion from future capital markets or as sanctions on output. Since these punishments are independent of the magnitude of default in the traditional models, the magnitude is always one hundred percent. Also, the cost of these punishments, compared with the benefits of complete debt repudiation, are not large enough to support magnitudes of debt empirically observed. Additionally, the traditional models ignore the distortionary effect of taxation with the assumption that the central-planner-sovereign can seize any amount of GDP to pay debt obligations, and, hence, is always solvent. The deadly riots in the streets of Athens in May 2010, in response to announced austerity measures, are a painful contradiction to this assumption. Even in less extreme situations, a sovereign is limited in the amount of tax revenue, relative to GDP, that it can raise. Even if a sovereign, weighing costs and benefits, wanted to repay debt, there are limits on what it can repay. Perhaps the market is trying to decide if Greece has the ability to honor its debt, a solvency concern, not addressed in the traditional literature on sovereign default.
Financial fragility models offer an alternative explanation of sovereign default as one of several multiple equilibria once fundamentals become weak (Cole and Kehoe, 1996, 2000). The implication of these models is that, among the countries with weak fundamentals, actual default will be determined by exogenous self-fulfilling expectations of default, where default is again one hundred percent. In actual experience, default is never complete.
In this paper, we argue that interest rate spikes in Greece and several other EMU countries, relative to Germany, reflect a potential fiscal solvency crisis, not a discretionary sovereign default crisis or a bad outcome of multiple equilibria. We develop a new model of sovereign default as the policy response to a fiscal solvency crises. Bohn (1998, 2007) has shown that a positive response of a government’s primary surplus to debt is sufficient to assure intertemporal government budget balance, implying fiscal sustainability and solvency. However, every government faces limits on its ability to raise taxes and reduce spending, which implies an upper bound on the present value of the primary surplus relative to GDP and an upper bound on the value of debt relative to GDP which the primary surplus can service. Fiscal policy, relating the government primary surplus to outstanding debt, can be combined with the government’s flow budget constraint to yield an expected time path for debt. When there is an upper bound on debt, current fiscal policy is sustainable only when debt does not violate the upper bound along this expected time path.
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