DP17357 Debt Sustainability with Involuntary Default
This paper studies public debt sustainability under the assumption that a country always tries to service its debt obligations. We assume that default decreases the level of resources available for debt service, which consist of the country’s primary surplus and the proceeds from new debt issuance. We show that our model encompasses the well-known result that, as long as r < g, countries can permanently run small deficits. In our model, this result holds if there is no decrease in resource availability following default. We thus show that, in the presence of involuntary default, a lesser decrease in resource availability in default –a lower cost of default– increases maximum sustainable debt. This is the opposite of what it is normally found in models that assume limited commitment and strategic default. We calibrate our model using data for the Eurozone and find that many countries have actual debt levels that are higher than their maximum sustainable debt. In discussing possible reasons for these high observed debt levels, we emphasize the role of expected GDP growth, growth volatility, and resource availability. We also model the role of the European Stability Mechanism (ESM). We show that while the ESM can increase the level of maximum sustainable debt, it also crowds out private lending.
