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How can governments borrow so much? - Zurich Open Repository and Archive


Habib, Michel A; Rochet, Jean-Charles (2013). How can governments borrow so much? NCCR FINRISK Working Paper Series 863, University of Zurich.

Abstract

Traditional models of sovereign debt assume that governments seek to maximize the long terminterests of their countries.We assume instead that governments borrow and default according to their own political interests. In particular they often have limited horizons and are reluctant to default strategically. This allows us to define a maximum sustainable debt to GDP ratio, and compute it as a function of the countrys fundamentals. We find that maximum sustainable debt varies a lot across countries, consistent with the notion of country specific debt (in)tolerance. Actual debt ratios are below their maximum sustainable levels, as governments seeking further terms in office fear debt-induced default that may jeopardize their prospects for reelection. The difference between actual and maximum sustainable debt ratios creates a "margin of safety" that allows governments to increase debt if necessary with little corresponding increase in default risk. The probability of default climbs precipitously once the margin of safety has been exhausted.

Abstract

Traditional models of sovereign debt assume that governments seek to maximize the long terminterests of their countries.We assume instead that governments borrow and default according to their own political interests. In particular they often have limited horizons and are reluctant to default strategically. This allows us to define a maximum sustainable debt to GDP ratio, and compute it as a function of the countrys fundamentals. We find that maximum sustainable debt varies a lot across countries, consistent with the notion of country specific debt (in)tolerance. Actual debt ratios are below their maximum sustainable levels, as governments seeking further terms in office fear debt-induced default that may jeopardize their prospects for reelection. The difference between actual and maximum sustainable debt ratios creates a "margin of safety" that allows governments to increase debt if necessary with little corresponding increase in default risk. The probability of default climbs precipitously once the margin of safety has been exhausted.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:1 July 2013
Deposited On:03 Mar 2014 08:06
Last Modified:05 Apr 2016 17:44
Series Name:NCCR FINRISK Working Paper Series
Official URL:http://www.zora.uzh.ch/93702/
Related URLs:http://www.nccr-finrisk.uzh.ch/media/pdf/wp/WP863_E1_B1.pdf
Other Identification Number:merlin-id:9270

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