Abstract
The objective of this research was to demonstrate the (nonlinear) risks of sovereign insolvency and explore the applicability of stochastic modeling in public debt management, given a structural economic model of stochastic government debt dynamics. A stochastic optimal control model was developed to model public debt dynamics based on the debt accounting identity, where the interest-growth differential obeys a continuous random process. This stochasticity represents both the interest rate risk of public debt and the variability of the growth rate of the nominal Gross Domestic Product combined. The optimal fiscal policy was analyzed in terms of the model parameters. The model was simulated, and results were visualized. The insolvency risk was demonstrated by examining the variance of the optimal process. The model was amended with hidden credit risk premia and fiscal multipliers, which forces the debt dynamics to be nonlinear in the debt ratio. The results, on the other hand, confirm that the volatility of the interest-growth differential is crucial in terms of sovereign solvency and in addition, it demonstrates the large risks stemming from the multiplier effect, which underlines the need for prudent debt management and fiscal policy.
Highlights
Public debt sustainability has become an increasingly important macroeconomic question for investors and sovereigns alike
The present study demonstrates and explores how, in particular, the volatility of the interest-growth differential affects government debt dynamics with hidden fiscal multipliers and hidden credit risk premiums
When the risk is understood in terms of the volatility of the debt ratio stemming from the interest-growth differentials, the model automatically has some features of asset liability management for the government, as the largest asset for a government is usually the future stream of tax income, which correlates to future nominal growth, given a level of overall taxation
Summary
Public debt sustainability has become an increasingly important macroeconomic question for investors and sovereigns alike. Fiscal sustainability and debt sustainability are especially important policy questions due to the global COVID-19 pandemic as governments have implemented various large fiscal backstops and support programs for households and firms. Automatic stabilizers and fiscal stimulus have caused the public debt ratios to increase. Fiscal crises stemming from unsustainable public debt can lead to an abrupt rise in taxes and deep cuts in welfare spending. If government spending is consistently unsustainable, debt to GDP ratios can spiral out of control. If government spending does not contribute to productivity growth and employment, but is used for import consumption spending, there is a risk that the policy stance is not sustainable. It is very difficult to assess when public debt is sustainable
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