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Fiscal Policy, Sovereign Default, and Bailouts

Falko Juessen and Andreas Schabert
University of Cologne, Working Paper Series in Economics No. 67, 2013

JEL codes: E32, H21, H63

Keywords: Discretionary fiscal policy, overborrowing, sovereign default, bailout loans, conditionality

This paper examines fiscal policy without commitment and the effects of conditional bailout loans. The government relies on distortionary taxation and decides between full debt repayment and costly default. It tends to overborrow due to myopia, which induces default to be a relevant policy option and provides a rationale to constrain sovereign borrowing. We consider a lump-sum balanced fund that others loans at a favorable price and conditional upon minimum primary surpluses. While the government prefers defaulting in the most adverse states, we find that it is willing to accept conditional loans in close-to-default states. These bailouts can lead to an increase in the mean debt price and a lower default probability that are associated with enhanced household welfare. Yet, these outcomes can be reversed when bailouts are too generous, while public debt never decreases in the long-run when bailout loans are available.

Fiscal Policy, Sovereign Default, and Bailouts