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A theory of debt accumulation and deficit cycles

3 June 2019

Tags: Austerity, Credit spreads, Fiscal tipping points, National debt

The issue: many advocate the thesis that a large government debt might hinder growth. For example, too much debt may signal upcoming tax increases, which discourages new investments. Do you remember Krugman v. Reinhart & Rogoff controversy? Reinhart & Rogoff theses seem to have influenced policymakers in the process of dealing with the European debt crisis of the early 2010s. In Reinhart and Rogoff own words:

“Our 2010 paper found that, over the long term, growth is about 1 percentage point lower when debt is 90 percent or more of gross domestic product.”

Carmen M. Reinhart and Kenneth S. Rogoff, April 26, 2013, The New York Times

Do such numbers exist? Paul Krugman believes they don’t. More recently, Alberto Alesina, Carlo Favero and Francesco Giavazzi have contributed to shift the debate on how to cure debt-sickness in their book on Austerity: When It Works and When It Doesn’t (2019, Princeton University Press). To cut a long story, the authors argue that austerity programs relying on cutting expenses are less painful and, sometimes, even expansionary, than austerity plans relying on increasing taxes.

I ask a related question. Too much debt might lead to default, and austerity plans might be unavoidable at some point. When? In a recent research paper, I argue that when governments have a “deficit bias,” such austerity plans might arrive too late to avert a crisis.

Slides are here.

Paper is here.

Category: Finance and macroeconomics

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Finance and macroeconomics

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