The sharp increase of sovereign debt internationally, since the 2008 global financial crisis, decisively contributed to several sovereign debt crises. The current COVID-19 pandemic and the fact that public debt remains high globally, have prompted a renewed interest in debt sustainability analysis (DSA) and in policy discussions concerning the most appropriate variables. We develop a normative DSA model to manage tail risk and optimize debt-financing decisions with sustainability conditions on debt stock and flow, under macroeconomic, financial, and fiscal uncertainty. We show that a risk management view alters a government’s debt-financing policy to manage tail risk better. Many uncertain variables confound the problem, and portfolio optimization using stochastic programming on scenario trees provides a versatile and effective tool to achieve sustainable debt dynamics. The model is an essential building block of the European Stability Mechanism framework to assess debt sustainability of eurozone member states, including the repayment capacity of crisis countries under €295bn assistance programs.
JEL classification: F32 F41Keywords: Current account Euro area Present value model Financial integration a b s t r a c t Current accounts have diverged substantially among euro area countries since the creation of the euro. This divergence has raised concerns about the sustainability of some member countries' external indebtedness. This paper uses an intertemporal model of the current account to analyze the fluctuations in current account balances experienced by euro area countries over the last three decades and to disentangle its determinants. We find that the model is not rejected for six of the ten euro area countries examined (Belgium, France, Italy, Netherlands, Portugal and Spain), although it tends to underestimate their current account volatility. For these countries, we derive the expectations about future income and relative prices, which, according to the model, underlie their current account balances. Expectations about future growth increased in all Southern European countries at the creation of the euro, but they diverged considerably by 2005. While in Portugal these expectations were below its historical mean by then, in Spain they were at an historical high.
Some pieces of empirical evidence suggest that in the U.S., over the last few decades, (i) wage inequality between-plants has risen much more than wage inequality within-plants and (ii) there has been an increase in the segregation of workers by skill into separate plants. This paper presents a frictionless assignment model in which these two features can be explained simultaneously as the result of the decline in the relative price of capital. Additional implications of the model regarding the skill premium and the dispersion in labor productivity across plants are also consistent with the empirical evidence.
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