Fiscal Policy, Overconsumption and Sovereign Debt Crisis

Using an equilibrium framework, we provide predictions that are consistent with the recent experience of sovereign debt crisis in Southern Europe: (ⅰ) generous public spending leads to high consumption, real estate bubbles, and large current account deficit and public debt relative to GDP, and (ⅱ) economies with large fiscal deficits ironically grew fast but became susceptible to a sudden financial and/or fiscal crisis. A surprising aspect of our model is that given the availability of cheap borrowing from EU countries with current account surplus, southern Europe countries with high public deficit can lock into a steady-state Ponzi growth equilibrium with asset bubbles. As long as loan-to-collateral value (LTV) ratio exceeds a certain threshold adopted in the banking sector, households continue to borrow at a lower interest rate of countries with current account surplus than the domestic rate while asset bubbles based on over-consumption can support a constant LTV, establishing a steady-state Ponzi growth equilibrium. When adverse shocks hit the economy and the expected loan-to-collateral value (LTV) ratio rises enough to move the economy into a self-fulfilling crisis region, the steady-state Ponzi growth equilibrium can break down with a bust of asset bubbles, even in the face of a mere psychological pessimism of investors.