Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

We develop a closed economy model in order to study the interactions among sovereign risk premia, fiscal limits and fiscal policy. Default risk premia reflect the market's expectations about the ability and willingness of the government to service its debt. The government's ability arises endogenously from fiscal limits implied by Laffer curves, while the government's willingness is determined by the flexibility of its fiscal policy. The model rationalizes different sovereign ratings across developed countries. The distribution of fiscal limits is country specific and depends on the size of the government, degree of the countercyclical policy responses, economic diversity and political uncertainty. The model also produces a nonlinear relationship between sovereign default risk premia and the level of government debt. The default risk premia of long-term bonds jump ahead of short-term bonds and provide early warnings of sovereign defaults. The nonlinearity is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. In addition, the model predicts substantial risk premia that are close to those observed, even when the probability of defaulting is remote. Default risk premia carry substantial economic costs, lowering consumption and output for extended periods