CFCM 16/03: Public debt sustainability in a globally integrated market

Abstract

Public debt is considered in a multi-country Diamond model, initially, where the deficit is exogenous, giving bifurcation maxima, and, subsequently, where it is determined by a policy trade-off between its deficit financing benefit and its crowding-out cost.   In the latter case, two effects arise: first, the Chang (1990) financing externality; and second, negative feedback from the debt to the deficit, initially discovered in the data by Bohn (1998), occurs as an endogenous outcome – and one which is strengthened by the degree of international financial integration.  The Chang effect implies countries will over-issue public debt under financial globalization, which will also threaten the sustainability of equilibrium in a nonlinear model.  The endogenous Bohn feedback effect, although inherently stabilizing, is not decisively so, causing bifurcations to remain, if policy-makers regard deficits and capital as imperfect substitutes.  However, for the perfect substitutes case, it works very powerfully even to eradicate the adjustment dynamics and to deliver higher-valued, corner-point maxima.  

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