Events at CERGE-EI

Leopold Zessner-Spitzenberg, Ph.D.

Vienna University of Technology, Austria

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Authors: Leopold Zessner-Spitzenberg and Martin Wolf

Abstract: We build a sovereign default model to understand the implications of rising safe interest rates for countries with high public debt. When debt levels are below a critical threshold, countries respond to higher interest rates by reducing their debt due to a dominant substitution effect. For high debt levels, in contrast, the same rate rise triggers even more debt - and possibly a slow-moving debt spiral - due to a dominant income effect. The seeds for a debt spiral are laid by a long phase of low interest rates: they imply that debt levels rise over time, making a future interest rate normalization more difficult. A successful interest rate normalization involves a credible path of rising interest rates, the speed of which must be intermediary: a too fast normalization leads to debt spirals, but a too slow one undermines incentives by the government to repay.

JEL Classification: E43, E44, F34, G01, H63
Keywords: sovereign debt, sovereign default, low interest rates, slow moving debt crisis, interest rate normalization

Full Text: Fear of Hiking? Rising Interest Rates in Times of High Public Debt