Collard, Fabrice, Habib, Michel, Panizza, Ugo and Rochet, Jean-Charles (2024) Sovereign Debt Sustainability with Involuntary Default. TSE Working Paper, n. 24-1599, Toulouse

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Abstract

We study the sustainability of sovereign debt under the assumption of involuntary and costly default: governments do their utmost to avoid default, which reduces the resources available for debt service. We show that costly default tightens Blanchard’s g > r condition. We derive a formula for a government’s maximum sustainable debt (MSD), which depends on the mean and the volatility of the country’s growth rate, the government’s maximum primary surplus, the risk-free rate, and the fraction of resources available to the government in default. We compute MSD for 12 Eurozone countries and examine the role of the European Stability Mechanism in increasing MSD.