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Working Paper
Optimal time-consistent government debt maturity
The current literature on a government's optimal debt maturity structure contends that by purchasing short-term assets and selling long-term debt, it is possible to fully insulate the economy against fiscal shocks. The required short and long positions are large relative to GDP and constant. The market value of debt adjusts automatically and the constant debt positions and fluctuating bond prices insulate against potential shocks. However, achieving the goal of averting future shocks depends on the government perfectly committing to the future fiscal policy, for without this sustained commitment, the large debt positions required to insure against future spending shocks are extremely expensive to service; moreover, the government faces a tradeoff between using the debt maturity structure to service its debt obligations and using it to protect against economic shocks. As the authors point out, in practice a government chooses tax, spending, and debt levels sequentially in each period, taking into account its outstanding debt portfolio and anticipating the behavior of future governments. The paper develops an alternative model of optimal debt maturity that solves the problem of a government's lack of commitment.
AUTHORS: Nunes, Ricardo; Debortoli, Davide; Yared, Pierre
DATE: 2016-05-17

Working Paper
Inflation, Debt, and Default
We study how the co-movement of inflation and economic activity affects real interest rates and the likelihood of debt crises. First, we show that for advanced economies, periods with procyclical inflation are associated with lower real interest rates. Procyclical inflation implies that nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. However, such procyclicality also increases sovereign default risk when the economy deteriorates, since the government needs to make larger (real) payments. In order to evaluate both effects, we develop a model of sovereign default on domestic nominal debt with exogenous inflation risk and domestic risk-averse lenders. Countercyclical inflation is a substitute with default, while procyclical inflation is a complement with it, by increasing default incentives. In good times, when default is unlikely, procyclical inflation yields lower real rates. In bad times, as default becomes more material, procyclical inflation can magnify default risk and trigger an increase in real rates.
AUTHORS: Hur, Sewon; Perri, Fabrizio; Kondo, Illenin O.
DATE: 2018-09-28

Working Paper
Risk Management for Sovereign Debt Financing with Sustainability Conditions
We develop a model of debt sustainability analysis with optimal financing decisions in the presence of macroeconomic, financial and fiscal uncertainty. We define a coherent measure of refinancing risk, and trade off the risks of debt stock and flow dynamics, subject to debt sustainability constraints and endogenous risk and term premia. We optimize both static and dynamic financing strategies, compare them with several simple rules and consol financing to demonstrate economically significant effects of optimal financing, and show that the stock-flow tradeoff can be critical for sustainability. We quantify the minimum refinancing risk and the maximum rate of debt reduction that a sovereign can achieve given its economic fundamentals, and extend the model to identify optimal timing for debt flow adjustments that allow the sovereign to go beyond these limits. We put the model to the data on three real-world cases: a representative euro zone crisis country, a low-debt country (Netherlands) and a high-debt country (Italy). These applications illustrate the use of the model in informing diverse policy decisions on sustainable public finance. The model is part of the European Stability Mechanism toolkit to assess debt sustainability and repayment capacity of member states in the context of financial assistance.
AUTHORS: Zenios, Stavros A.; Consiglio, Andrea; Athanasopoulou, Marialena; Moshammer, Edmund; Gavilan, Angel; Erce, Aitor
DATE: 2019-06-01

Working Paper
Official Debt Restructurings and Development
Despite the frequency of official debt restructurings, little systematic evidence has been produced on their characteristics and implications. Using a dataset covering more than 400 Paris Club agreements, this paper fills that gap. It provides a comprehensive description of the evolving characteristics of these operations and studies their impact on debtors. The progressive introduction of new terms of treatment gradually turned the Paris Club from an institution primarily concerned with preserving creditors? claims into an instrument to foster development in the world?s poorer nations, among other objectives. Our study finds that more generous restructuring conditions involving nominal relief are associated with an acceleration of per capita GDP growth, a reduction of poverty and inequality, and an increase in public health budgets. We also find that countries receiving nominal relief tend to receive lower aid flows subsequently, the opposite being the case for countries receiving high reductions in the net present value of their obligations, but no nominal haircuts.
AUTHORS: Cheng, Gong; Erce, Aitor; Diaz-Cassou, Javier
DATE: 2018-04-20

Working Paper
Fiscal Austerity in Ambiguous Times
This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimally policies that resemble "austerity" measures. Optimal policy prescribes higher taxes in adverse times and front-loaded fiscal consolidations that lead to a balanced primary budget in the long-run. This is the case when interest rates are sufficiently responsive to cyclical shocks?that is, when the intertemporal elasticity of substitution is sufficiently low.
AUTHORS: Ferrière, Axelle; Karantounias, Anastasios G.
DATE: 2016-03-01

Working Paper
The Implications of a graying japan for government policy
Japan is in the midst of a demographic transition that is both rapid and large by international standards. As recently as 1990, Japan had the youngest population among the Group of 6 large, developed countries. However, the combined effects of aging of the baby boomer generation and low fertility rates have produced very rapid aging. Japan now finds itself with the oldest population among the Group of 6, and its population will continue to age at a rapid pace in future years. Aging is already placing a burden on government finances, and Japan's ability to confront the negative fiscal implications of future aging is constrained by its very high debt-to-GDP ratio. We find that Japan faces a severe fiscal crisis if remedial action is not undertaken soon, and we analyze alternative strategies for correcting Japan's fiscal imbalances.
AUTHORS: Braun, R. Anton; Joines, Douglas H.
DATE: 2014-11-01

Working Paper
Optimal Fiscal Policy with Recursive Preferences
I study the implications of recursive utility, a popular preference specification in macrofinance, for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are substantially altered. The planner overinsures by taxing less in bad times and more in good times, mitigating the effects of shocks. At the intertemporal margin, there is a novel incentive for introducing distortions that can lead to an ex-ante capital subsidy. Overall, optimal policy calls for a much stronger use of debt returns as a fiscal absorber, leading to the conclusion that actual fiscal policy is even worse than we thought.
AUTHORS: Karantounias, Anastasios G.
DATE: 2013-09-01

Working Paper
A Tax Plan for Endogenous Innovation
In times when elevated government debt raises concerns about dimmer global growth prospects, we ask: How can the government provide incentives for innovation in a fiscally sustainable way? We address this question by examining the Ramsey problem of finding optimal tax and subsidy schemes in a model in which growth is endogenously sustained by risky innovation. We characterize the shadow value of growth and entry in the innovation sector. We find that a profit tax is required to replicate the first-best in order to balance the externalities associated with innovative activity. At the second-best, the profit tax is designed to optimally respond to growth shocks above and beyond what is prescribed by the standard tax-smoothing incentives in economies with exogenous growth. The interplay of risk and innovation opens a new margin for optimal taxation.
AUTHORS: Croce, Mariano; Karantounias, Anastasios G.; Raymond, Stephen; Schmid, Lukas
DATE: 2017-11-01

Working Paper
Optimal Time-Consistent Taxation with Default
We study optimal time-consistent distortionary taxation when the repayment of government debt is not enforceable. The government taxes labor income or issues noncontingent debt in order to finance an exogenous stream of stochastic government expenditures. The government can repudiate its debt subject to some default costs, thereby introducing some state-contingency to debt. We are motivated by the fact that domestic sovereign default is an empirically relevant phenomenon, as Reinhart and Rogoff (2011) demonstrated. Optimal policy is characterized by two opposing incentives: an incentive to postpone taxes by issuing more debt for the future and an incentive to tax more currently in order to avoid punishing default premia. A generalized Euler equation (GEE) captures these two effects and determines the optimal back-loading or front-loading of tax distortions.
AUTHORS: Karantounias, Anastasios G.
DATE: 2017-11-01

Working Paper
Exposure to international crises: trade vs. financial contagion
I identify new patterns in countries' economic performance over the 2007-2014 period based on proximity through distance, trade, and finance to the US subprime mortgage and Eurozone debt crisis areas. To understand the causes of the cross-country variation, I develop an open economy model with two transmission channels that can be shocked separately: international trade and finance. The model is the first to include a government and heterogeneous firms that can default independently of one another and has a novel endogenous cost of sovereign default. I calibrate the model to the average experiences of countries near to and far from the crisis areas. Using these calibrations, disturbances on the order of those observed during the late 2000s are separately applied to each channel to study transmission. The results suggest credit disruption as the primary contagion driver, rather than the trade channel. Given the substantial degree of financial contagion, I run a series of counterfactuals studying the efficacy of capital controls and find that they would be a useful tool for preventing similarly severe contagion in the future, so long as there is not capital immobility to the degree that the local sovereign can default without suffering capital flight.
AUTHORS: Grant, Everett
DATE: 2016-08-01

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