Chapter 18 > Sovereign Debt & Default Flashcards
What happens to government borrowing in recessions and booms?
There is a natural tendency for government borrowing to increase in recession and fall in booms. This occurs because government revenue tends to fall in recessions (due to falling tax revenues) while spending rises (on transfers such as unemployment benefit).
What are automatic stabilisers?
Automatic stabilisers are ongoing government policies that automatically adjust tax rates and transfer payments in a manner that is intended to stabilise incomes, consumption, and business spending over the business cycle.
They are a tool to combat economic slumps and recessions.
What is the actual deficit formula?
Actual Deficit = Structural Deficit + Cyclical Deficit (all in %GDP)
How do we estimate the structural and cyclical deficit?
To estimate Structural deficit:
- We need to estimate potential GDP and theoretical tax revenues, and government spending
associated to it.
- A possible approach is applying estimated elasticities to actual revenue and spending figures (ignore the formulas).
Once Structural deficit is estimated, subtracting it from Actual gives the Cyclical deficit.
What is the cyclical structure of the deficit?
It’s the part of the deficit that is influenced by the state of an economy.
This part of a deficit, e.g. during a recession, should not alarm that much as it most probably will disappear with the recovery.
What is the structural part of the deficit?
It’s the part of the deficit that is not influenced by the state of an economy.
Is permanent, unless some laws are passed to reduce it.
Is the one that must be sustainable over time (ideally zero).
Might be large and hidden by a positive cyclical contribution during expansions.
Why can deficits rise?
Since GDP—in nominal terms—is likely to rise over time, it follows that the nominal stock of debt can also rise. For that reason, it can be sustainable for governments to consistently run overall deficits without finding its debt growing out of control. However, there will be a limit to the sustainable deficit—the limit being the deficit that is the largest consistent with the debt-to-GDP ratio.
Which is the debt sustainability rule?
Governments can run deficits every year, and let debt increase as long as:
- Deficit < Nominal GDP change.
- If Deficit = nominal GDP change, then the ratio of Debt/GDP will remain stable.
r < g rule.
Which is the r < g rule?
Debt can be sustainable as long as interest rates on debt (r) are lower than nominal GDP
growth (g).
- This condition holds both for real and nominal GDP growth
If r > g, then the government needs to generate primary surpluses to be able to cover interest payments and keep the debt ratio stable.
What is the inter-temporal budget constraint?
The current stock of government debt today must equal (or be less than) the present discounted value of all future primary surpluses.
What are contingent liabilities?
These are government liabilities that will only become certain on the occurrence of some future event, but are nonetheless very likely to have an impact on future spending and revenue.
The most important contingent liabilities that developed countries face is future state pension payments and the associated health costs of an ageing population. These have the potential to generate large and sustained future deficits and so should be factored into tax and spending decisions today.
What is sovereign default?
Type of default where the government is no longer and willing to service its debt and so fails to honour promised interest payments.
What is meant by the sovereigns have the “choice” to default?
Sovereigns can default when they want (unlike corporations) because they draft their laws (and can ignore international law), and so can choose not to pay their creditors whenever they wish. When those creditors are not citizens, there isn’t even impact on the governments popular support.
What is another way governments can deal with high debt?
Printing money -> inflation
What is the implication of the original sin?
The requirement imposed by creditors that government issue debt in foreign currency. This is so that the issuer (government) cannot erode the value of their claims through domestic inflation.
In countries with low credibility debt is issued in international currencies and with short maturities (implication of the original sin).
