Does austerity pay off?

Born, Benjamin; Müller, Gernot J.; Pfeifer, Johannes

Does austerity pay off?

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Citation

Born, B, Müller, G, Pfeifer, J. Does austerity pay off?. 2016. handle: http://hdl.handle.net/10230/26191

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Abstract

We investigate if a reduction of government consumption lowers the sovereign default premium. For this purpose we build a new data set for 38 emerging and developed economies. Results vary along three dimensions. First, the time horizon: the premium declines, but only in the long run. Second, initial conditions: the premium increases in the short run, but only if it is already high. Third, size: the short-run response of the premium increases disproportionately as government consumption is reduced. We rationalize these findings in a structural model of optimal sovereign default where default risk is priced in an actuarially fair manner.