Viral V Acharya (NYU Stern, CEPR and NBER) and Raghuram G Rajan (Chicago Booth and NBER) 1  In some cases, governments took on excess debt and deficits prior to the financial crises  Greece, Italy  United States?  In others, governments took on excess debt and risks while rescuing failed banks or stimulating the economy  Ireland  United States?  And, in yet others, private debts and growth slowdown engulfed governments too (Spain) 2  Governments keen to expand fiscally.  In favor of their own vote-bank.  Government reluctant to cut back fiscally, even in wake of mounting debt on balance-sheets.  Sovereign debt held substantially by own banks.  Sovereign debt used in repos/as collateral to facilitate financial transactions.  Sovereign default will cause “collateral damage”  Broner-Martin-Ventura (2010), Bolton-Jeanne (2011), Gennaioli-Martin-Rossi (2011), …  Is this why markets keep lending to sovereigns? 3 1 8 . e m o H 6 e . r a h s of n a 4 e . m 2 . 0 CY SI BE AT NL UK LU FR FI SE PT DE IE DK IT MTGRES HU PL Source: Acharya, Drechsler and Schnabl (2011) 4  Governments are short horizon and populist.  They care about current cash flows.  They will not default so long as they can borrow.  No net repayment  They can pass on the burden of repaying debt to future governments.  As their financial sectors get more entangled with sovereign debt, the costs of default increase.  Net debt repayments are this way enforceable.  And knowing this, creditors lend even to poor governments with low default costs.  Myopia may be a way for governments to commit! 5  Country, government, private sector, banks  Governments have short horizon – rule for 1 period & behave as if it is their last period.  Want to maximize spending on populist schemes  Period 1  Country enters period with legacy debt repayment (cid:1830) due of (1+r) (cid:2868)  (cid:1830) Can raise new debt (cid:2869)  (cid:1872) Can levy taxes (cid:2869)  Question: What is sustainable? (cid:2868) 6  Private sector (corporations/households)  (cid:1831) Enter period with some endowment (cid:2868)  (cid:1863) Chose to invest in projects keeping in mind (cid:2869) current and prospective tax rates.  Rest invested in government bonds (only financial asset), e.g., as savings into a financial sector  Taxes thus have a “crowding out” effect on private investment; conversely, a “crowding in” effect for savings and government debt 7  Default disrupts domestic financial sector Dom zD (1  r )  Cost of default at date 2 equals 1 where For Dom D  D  D 1 1 1 (cid:1878)  is the vulnerabilityof the financial sector, exogenous for now; endogenized later…  Several explanations  Banks may hold government bonds for liquidity and safety  Bonds may serve as collateral in inter-bank flows 8 ___________________________________________________________________ Period 1 Period 2 + t=0 t=1 t=1 t=2 (1) Existing (2) Govt (3) Short (4) Govt (5) New govt (6) Long run foreign debt decides run collects taxes comes in; corporate D and whether to corporate t f (k ); Govt decides output f (k ) 0 1 1 1 2 1 corporate announce output f (k ) Govt repays whether to realized; Govt 1 1 endowment default on realized; debt of announce collects taxes E . legacy debt; D (1+r) and default on t f (k ); 0 0 2 2 1 It announces raises new legacy debt; Govt repays tax rate t ; debt (if no announces debt of 1 Corporate default): tax rate t ; D (1+r) 2 1 sector makes Externally (if no default) investment financed debt k and saves is DFor , 1 1 the rest (E - 0 domestically k ) 1 financed debtDDom. 1 9  Corporations/households: How much to invest in production and how much to allocate to financial savings (domestic government bonds)?  Period 1 government  Whether to service legacy debt or default  How much to tax  This determines how much it will spend  Period 2 government  Whether to service legacy debt or default (cid:3014)(cid:3028)(cid:3051)  (cid:1872) How much to tax (trivially equal to ) 10