Fiscal unions redux

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Springer;Society for the Advancement of Economic Theory (SAET), Economic Theory, ISSN: 0938-2259, Vol: 64, Issue: 4, Page: 741-776, No: 6

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10.1007/s00199-016-1008-x; 10.1007/s00199-017-1085-5; 10.1007/s00199-016-1016-x; 10.1007/s00199-017-1088-2
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Cristina Arellano; Timothy J. Kehoe; Herakles Polemarchakis
Springer Nature
Economics, Econometrics and Finance; Debt crisis, Rollover crisis, Recession, Eurozone; Cross-country externalities, Cross-country insurance, Cross-country transfers, Fiscal externalities, International financial markets, International transfers, Optimal currency area; Incomplete markets, Sovereign debt, Financial crises
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This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government’s inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.