Public Default Dynamics
by Betty C. Daniel of the University at Albany - SUNY
Abstract: This paper provides a dynamic model of a public debt crisis in which fiscal insolvency is the cause. The insolvency is created by a combination of a passive fiscal policy with an upper bound on the long-run budget surplus, yielding risky government debt, and a string of bad luck. As debt rises and a crisis approaches, the interest rate rises, due to a risk premium on debt in anticipation of possible default. A position, in which the contractual value of debt under passive fiscal policy exceeds the maximum expected present-value surplus, is infeasible. Should passive fiscal policy require such a point, a crisis occurs. Crisis resolution includes a promise of fiscal reform, with a switch to active fiscal policy as in the Fiscal Theory of the Price Level (FTPL). The switch creates larger near-term surpluses, which serve to raise the expected present-value surplus, and greater exchange rate flexibility, which eliminates the default premium on debt. If the present-value surplus is still too low relative to debt after the policy switch, default is necessary.
Keywords: Default, Financial Crisis, Currency Crisis, Debt Crisis, Regime Switching, Fiscal Theory of the Price Level.
Previously titled: Sovereign Default Dynamics