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Working Papers (2001), ESSEC Business School

Public Debt: From Insolvency to Illiquidity Default


Most studies explain default on public debt either as the discretionary decision of a short-sighted government, or as the consequence of an accidental increase in public deficits. In this paper, default is brought about by the refusal of rational private investors to roll over the debty of a seemingly solvent government. True, default may occur after a long sequence of adverse shocks because the ballooning debt is no longer consistent with the going fiscal rule. But this rather small risk of insolvency brings about a much more severe illiquidity risk, as investors would refuse to lend to a government whose debt exceeds a critical threshold. Central to this analysis is the expectations upgrading process, and the recursive calculation of critical threstholds, until convergence is achived. It comes out that the debt level insulating the government from illiquidity default is much lower thatn the insolvency threshold. This result would ask for a more cautious evaluation of contemporary fiscal policies, which, so far, has focused almost exclusively on solvency criteria.

BESANCENOT, D., HUYNH, K. and VRANCEANU, R. (2001). Public Debt: From Insolvency to Illiquidity Default. ESSEC Business School.