Fiscal Austerity during Debt Crises∗

This paper constructs a dynamic model of government borrowing and default. The government faces a fiscal constraint in that it cannot raise tax rates. By defaulting on the debt, the government can increase domestic consumption. Two types of default arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because the government cannot service the debt due to its 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 the default. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation. ∗The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. E-mails: [email protected]; [email protected]