The rationale for fiscal austerity when countries face rollover risk
Juan Carlos Conesa and Timothy J. Kehoe develop a quantitative sovereign debt model that incorporates endogenous tax policy and the risk of rollover crises, extending prior frameworks by Cole and Kehoe (1996, 2000) and Conesa and Kehoe (2017). Key features include:
- Advance commitment: The government sets the tax rate at the start of each period, before the realization of creditor sentiment, which can trigger a rollover crisis (modeled via a “sunspot” variable).
- Labor response: Labor supply is endogenous, and higher taxes lower labor supply, reducing output and amplifying the costs of austerity.
- Debt maturity: Debt has finite maturity, matching empirical patterns in Europe.
- Equilibrium zones: The model defines three zones based on debt levels: a safe zone (no crisis risk), a preemptive austerity zone (high taxes deter panics but are costly), and a crisis zone (at risk of self-fulfilling defaults).
- Policy computation: The optimal tax and debt dynamics are solved numerically, calibrated to European data from the 2008–12 recession.
Findings
- Preemptive austerity mechanism: Announcing and maintaining higher taxes up front can expand the safe zone for sovereign debt, preventing panics and access restrictions to cheap credit. This policy eliminates the usual crisis warning signals (such as high bond yields), as panic is averted.
- Optimality of austerity: Choosing fiscal tightening can be optimal even during deep recessions if it preempts rollover crises. This logic reverses the typical Keynesian prescription, explaining episodes where countries (e.g., Germany post-2008) pursued surpluses despite low borrowing costs.
- Transitional dynamics: Although ex-ante optimal, the elevated tax rate is ex-post suboptimal, prompting governments to reduce debt over time so that high taxes are no longer needed.
Preemptive Austerity with Rollover Risk
Authors: Juan Carlos Conesa, Timothy J. Kehoe
From: Federal reserve Bank Of Minneapolis
When governments must choose austerity
Vadim Elenev, Tim Landvoigt, and Stijn Van Nieuwerburgh introduce the concept of an “austerity threshold” as a novel measure of fiscal capacity—specifically, the debt-to-GDP level above which governments must raise fiscal surpluses to ensure debt safety. The authors construct a dynamic stochastic general equilibrium model within the New Keynesian tradition, incorporating several distinctive features. A key innovation is the intermediation sector that uses government debt to produce safe, liquid assets, creating convenience yields that reduce government borrowing costs.
The fiscal policy framework features endogenous regime-switching based on debt levels rather than continuous adjustment. For moderate debt ratios, policy focuses on macroeconomic stabilization while disregarding debt sustainability. Once debt crosses the endogenous threshold, policy shifts to austerity through either tax increases or spending cuts. The authors develop a sophisticated algorithm to determine this threshold that simulates 50,000 alternative 80-year histories to ensure debt safety under all possible shock paths. The model is calibrated using post-WWII U.S. data, matching key macroeconomic moments while allowing debt-to-GDP ratios to span from roughly 20% to 300% of GDP.
Findings
- Fiscal capacity estimates: The calibrated model estimates the U.S. austerity threshold at 189% of GDP for tax-based austerity and 174% for spending-based austerity—both significantly above current debt levels around 100% of GDP. This suggests the U.S. government can delay fiscal adjustments well beyond current Congressional Budget Office projections of 156% debt-to-GDP by 2055.
- Differential impacts of austerity types: The choice between tax increases and spending cuts generates markedly different macroeconomic outcomes. Tax austerity acts as an inflationary negative supply shock, depressing labor supply and output while requiring the central bank to raise rates further. Conversely, spending austerity operates as a deflationary negative demand shock, allowing the central bank to cut rates sharply and actually stimulate output in the austerity region.
- Critical role of risk premia: The analysis reveals that realistic risk aversion and safety premia are essential for fiscal capacity. In a counterfactual with low risk premia, fiscal capacity drops dramatically from 189% to 138% (tax austerity) and from 174% to 105% (spending austerity), demonstrating how precautionary savings demand keeps borrowing costs manageable.
- Policy implications: Several policies can expand fiscal capacity but with trade-offs. Shortening average debt maturity or requiring banks to hold more government debt through liquidity regulation both increase fiscal capacity but crowd out productive investment. Monetary policy can enhance capacity not by lowering rates but by credibly committing to raise rates during high inflation in austerity regions.
- Regime uncertainty: Perhaps most strikingly, uncertainty about the type of austerity regime sharply reduces fiscal capacity. When austerity can switch between spending cuts (75% probability) and tax increases (25% probability), fiscal capacity shrinks to just 115% of GDP due to the opposing effects of the two policies on bond yields and debt valuation.
The Austerity Threshold
Authors: Vadim Elenev, Tim Landvoigt, Stijn Van Nieuwerburgh
From: Johns Hopkins University, University of Pennsylvania – The Wharton School, Columbia University
