Persistent unemployment, sovereign debt crises, and the impact of haircuts

After 2008, the Southern European economies suffered a strong and persistent increase in unemployment. Rising government bond spreads necessitated the implementation of austerity policies. Austerity however, may increase unemployment. If workers lose human capital during unemployment spells, the economy's future production potential and thus the fiscal capacities to serve public debt will decline, aggravating a sovereign debt crisis. Debt renegotiations can help to avoid the costs of austerity. I develop a dynamic stochastic model of sovereign debt with long-term debt, endogenous haircuts and skill loss during unemployment to study optimal fiscal policy in sovereign debt crises. In a quantitative exercise, I find that with higher intensity of the skill loss, ex ante, the government issues less debt and the pro-cyclicality of fiscal policy declines. For Portugal, the model predicts debt renegotiations as optimal fiscal response in 2011 with a medium-run unemployment reduction of up to 3.63 percentage points.