73/2012 Marcus Miller, Neil Rankin and Lei Zhang

European capital markets show increasing concern about the extent of sovereign debts and their sustainability. Here we explore some insights that the Overlapping Generations (OLG) framework has to offer on such issues. The OLG framework implies, for example, that there is a limit to the amount of debt that may be sustained in a closed economy - with high debt raising interest rates and crowding out capital formation. But capital market integration with less indebted partners allows for a fall in interest rates as a result of borrowing from one's neighbour. Indeed we find that - in equilibrium - most of the debt of a high indebted country will be transferred to partner countries. Rather like ECB discount policy, our formal analysis is conducted without taking sovereign default risk properly into account, however. We go on to discuss three possible sources of default risk - creditor panic, exogenous interest rate shocks and "over-borrowing" - and we emphasize the need for comparative statics to be complemented by disequilibrium dynamics.

Culture and Development