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Preemptive Austerity with Rollover Risk

Staff Report 654 | Revised March 25, 2024

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Authors

Juan Carlos Conesa Stony Brook University
Timothy J. Kehoe Consultant, University of Minnesota, and National Bureau of Economic Research
Preemptive Austerity with Rollover Risk

Abstract

By _preemptive austerity_, we mean a policy that increases taxes to deter potential rollover crises. The policy is so successful that the usual danger signal of a rollover crisis, a high yield on new bonds sold, does not show up because the policy eliminates the danger. Mechanically, high taxes make the safe zone in the model - the set of sovereign debt levels for which the government prefers to repay its debt rather than default - larger. By announcing a high tax rate at the beginning of the period, the government ensures that tax revenue will be high enough to service sovereign debt becoming due, which deters panics by international lenders but is ex-post suboptimal. That is why, as it engages in preemptive austerity, the government continues to reduce the level of debt to a point where, asymptotically, high taxes are no longer necessary.




Published in: _Journal of International Economics_ (Vol. 150, July 2024, article 103914), https://doi.org/10.1016/j.jinteco.2024.103914.