Government debt:

definitions & dynamics

Public Sector Economics for EBE
Lecture 5
Teacher: Harrie Verbon
Spring 2015
Source: Grtner, Macroeconomics, Ch 14
1

Content of the lecture

definitions and financing
burden of the debt I:
what if deficit is always positive (but constant)
Domar rule

burden of the debt II:

what if primary surplus is always constant
(positive or negative) see: Macro3

Debt explosion, default and rating agencies

2

Government budget
REVENUE

EXPENDITURE

T tax revenues

G government spending

M money financing

iB interest payments

???

T + ??? + M

G + iB

Definitions: Deficits and Debt

Primary surplus
Public deficit
Deficit financing
Additional bonds
Public debt
Interest payments

S=TG
F B= G T + iB
F = ?? + M
B = ?? ??

Deficit financing (some basics)

Money creation: Central Bank is needed
(less likely in a federation, but possible)
Debt = emission of bonds
Bond = a face value (say 100) and a fixed
interest rate or coupon of say 2% leading
to annual payments of 2
Bonds can be sold or bought at the market
against a price that can be different from the
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face value

Government bonds (some basics)

Bond price will be lower than face value
e.g. if investors fear the government might
be less able to meet the annual interest
payments
Then the current yield rises:
suppose resale face value goes down to 80
actual yield goes up from 2% to ?????
6

Government bonds: historic note

Source: the ascent of money by Niall Ferguson

Which country/state was the first to

issue bonds and when?

Government bonds: historic note

Source: the ascent of money by Niall Ferguson

Government bonds & debt have historically

always been linked to the financing of wars
Government bonds financed wars, but wars
decreased the price of existing bonds as a debt
crisis could arise in the case of defeat

Debt and wars and/or crises

Public debt in advanced (brown), emerging (blue)

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and low-income (red) countries

But, between (similar) countries big

differences possible:
Germany & Austria in 14-18 no access to
international bonds market

The War also had to be financed by money

creation
What is the effect of inflation on the
possibility of bond finance???

10

Definitions: Deficits and Debt

Primary surplus
Public deficit
Deficit financing
Public debt
Interest payments
Deficit (rewritten)

S=TG
F = G T + iB
F = B + M
B +1 = B + B
iB
F = ???

11

Content of the lecture

definitions and financing
burden of the debt I:

DONE

NEXT

what if deficit is always positive (but constant)

Domar rule

burden of the debt II:

what if primary surplus is always constant
(positive or negative)

Debt explosion, default and rating agencies

12

Will the debt explode if deficit is constant?

Notation and assumptions

Abstain from money M = 0 and price level

is constant: all entities are in real terms
Y is real income with growth rate y:
Y = (1 + y)Y1
Consider as %Y: b=B/Y, f = F/Y, etc.
math note: f = F/Y = B+1 /Y B/Y = (B+1/Y+1)(Y+1/Y) B/Y=
= b+1(1+y) b
Also, from F = iB S
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we get:
f = ib s

Question: is it a problem if f>0 and constant until the

end of time?
Consider:
ft =bt+1(1+y) - bt
(1)
or:
(2)
bt+1 = (ft + bt)/(1+y)
Suppose: f t= f for t=-, ,0
Then use (1) or (2): b1 = f/y + 0
b2 =

(f + b1)/(1+y) =[f + {f/y}/(1+y)= f/y

14

math note: you can also take ft = f, bt=b in (1) to get

f=by

Calculate the sum of a (finite or infinite)

geometric series
Sum =

f/(1+y) +f/(1+y)2 + .+ d- /(1+y)

Sum(1+y) = f + f/(1+y) + f/(1+y)2 + .+ d- /(1+y)

Sum(1+y) Sum = f
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DOMARs rule: b= f/y

If f had been constant for a long time.
b will converge to a constant: b= f/y
So: a constant budget deficit is no problem
as long as the constant debt can be financed
(is sustainable) and primary surplus can be
adapted!
Notice: b/f > 0 ; b/y < 0 ; b/i = 0
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Primary surplus and deficit

Definition
f = ib s
Domar
b = f/y
(1) + (2) f = if/y s
(3)
f (i/y 1) = s

(1)
(2)
(3)

If i > y

s>0
s<0

f >< 0 ???
f >< 0 ???

If i < y

s<0
s>0

f >< 0 ???
f >< 0 ???
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Constant deficit or debt can be maintained, but:

If f>0 a positive primary surplus, s>0, is necessary
from some period onwards (if i>y)
Out of equilibrium f can only remain constant if
the primary surplus is adapted (as interest
payments change)
Notice that in the beginning of time (Adam &
Eve) there is no debt (b- =0) and so f>0 implies
a primary deficit (G>T) is created,
But for future generations G<T has to hold, unless
i<y (is not very probable to hold indefinitely)
Conclusion: the government can have a18debt
forever, but not unrestricted: s>0, if i>y

Content of the lecture

definitions and financing
burden of the debt I:

DONE
DONE

what if deficit is always positive (but constant)

Domar rule

burden of the debt II:

NEXT

what if primary surplus is always constant

(positive or negative)

Debt explosion, default and rating agencies

19

Some simple debt dynamics: from Macro3

Definition
Differentiate (1)

f B/Y

(1)

B (bY) = b Y + Y b

(2)

Y/Y y;(2) f = b Y/Y + b = by + b

(3)

as:

f = ib s

(4)

we get

b = (i y)b s

(5)

Equilibrium value of debt rate b=0: b* = s/(iy)

20 but s
Notice: we no longer take f as constant,

Draw the graphs for yourself for the cases:

i>y
i>y
i<y
i<y

&
&
&
&

s<0
s>0
s<0
s>0

Find out whether equilibrium is stable

(consult Grtner, Ch. 14, if necessary)
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Conclusion on dynamics of debt:

If i>y the debt process is inherently unstable with a
given and constant primary surplus S=TG
Instability: if b>b* the debt will explode

But:
before the explosion a default occurs:
Debt explosion, default and rating agencies
22

Content of the lecture

definitions and financing
burden of the debt I:

DONE
DONE

what if deficit is always positive (but constant)

Domar rule

burden of the debt II:

DONE

what if primary surplus is always constant

(positive or negative)

NEXT
Debt explosion, default and rating agencies
23

Sovereign default: definition

A sovereign default is the failure or refusal of
the government of a sovereign state to pay back
its debt in full. It may be accompanied by a
formal declaration of a government not to pay
(repudiation) or only partially pay its debts
(due receivables), or the de facto cessation of
due payments.
A default can be generated by the financial
market due to self fulfilling prophecies
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(Grtner, p. 426-434)

Default and interest rate

1: the financial market

A default with probability , affects the

interest rate i on government bonds
Suppose a risk-free asset with i0
Arbitrage condition on investment (risk
neutrality):
(1+ i0) = (1 )(1+ i), so that
i = ( i0 + )/(1 )
Notice: i/ > 0

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Default and interest rate

2: behavior by government

The higher the interest rate, the higher debt

growth, the higher the temptation to default:
= 0 + i
(>0)
We had:
i = ( i0 + )/(1 )
Solve:
i2 (1 0 )i + i 0 + 0 = 0
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i.e. two solutions

Default and interest rate: graphical

arbitrage condition
interest rate i

determination of default
risk

Two possible equilibria

might occur:
- low risk, low interest rate
- high risk, high interest rate
Check which of the two is
stable

i0
i1

default risk

Default and interest rate: graphical

arbitrage condition
interest rate i

determination of default
risk
Check:
If the default risk 1, the
interest rate rises to
Interpretation?

=1

default risk

Credit rating and default

A default risk cannot be observed directly
Rating agencies (Moodys, S&P, Fitch) asses the
solvency of a government by (mostly 21) discrete
ratings from AAA, AA+, , to D
with AAA=0, no risk at all to D=21 for certain
default.
Agencies assessment takes same factors into
account as the government
So, rating is some linear transformation of as
perceived by the government
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Default and interest rate: graphical

arbitrage condition
interest rate i

rating line
Check:
If the rating is above the
solvency threshold as with
R1 default becomes a selffulfilling prophecy

rating R
R1 D
AAA
If, for good or bad reasons, the rating is like R1 the country will no
longer be able to get loans from the market

Avoiding default by improving

fundamentals
Default risk is determined by:
interest rate
other factors: primary surplus, the size of the debt, etc.
determine the location of the rating line.

Increasing primary surplus and, therefore,

decreasing the debt shifts the default risk (or
rating line) up: fiscal austerity
Q: Adapt the figure such that due to fiscal
austerity default has become less likely
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Conclusions
A constant deficit can be maintained
indefinitely, but primary surplus has to be
adapted
A constant primary surplus can lead to
debt explosion (if it is too high and r > y)
Debt explosion can be a self-fulling
prophecy due to credit rating
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