On the Time Inconsistency of International Borrowing in an Optimal Growth Model

This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment. We study the relation between optimal savings and investment, and the current account, in the transition towards the balanced growth path, and derive the implications of financial openness for both the transition path and the balanced growth path. A comparison with financial autarky reveals that, to the extent that countries start from different initial conditions, and there is pre-commitment to debt repayment, financial openness is beneficial for both “poor” and “rich” countries, as it allows them to engage in mutually beneficial inter-temporal trade. During the adjustment process, relatively “poor” countries experience higher consumption and investment compared to autarky, and thus cumulate current account deficits. There is an inter-temporal tradeoff, in that they experience lower steady state consumption, due to the need to service their accumulated foreign debt. The opposite happens in relatively “rich” countries. The inter-temporal tradeoffs implied by financial openness result in a time inconsistency problem. “Poor” countries reach a point in the adjustment process at which it is welfare improving to renege on their commitment to repay their foreign debt. In the absence of sufficient pre-commitment mechanisms, international lenders anticipate these incentives, and international borrowing and lending are driven to zero. This time inconsistency problem can thus explain both the Feldstein-Horioka puzzle and the Lucas paradox that capital does not flow from “rich” to “poor” countries. Credible sanctions in the case of default and ceilings on international borrowing are analyzed as partial solutions to the time inconsistency problem of international borrowing.

Keywords: time inconsistency, international borrowing, optimal growth, financial openness, debt default
JEL Classification: F43 F34 O11 D91 D92

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Financial Openness versus Autarky in a Neoclassical Growth Model

This paper compares financial openness with autarky in a neoclassical growth model, with adjustment costs for investment. We analyse the relation between growth and the current account in the transition towards the balanced growth path, and derive the implications of the two financial regimes for the balanced growth path. For an economy with an initial capital stock which is lower than the rest of the world, output (GDP) per capita on the balanced growth path is the same under financial openness and autarky. However, Gross National Product (GNP) and consumption per capita are lower under financial openness than under autarky. The reason is that the economy has to pay interest on the foreign debt it has accumulated during the transition. During the transition, the economy runs current account deficits and accumulates net foreign debt. The opposite applies to an economy, whose initial capital stock is higher than the rest of the world. There are benefits from financial openness and inter-temporal trade for either type of economy, as, during the transition, the path of the world real interest rate differs from the path of autarky real interest rates for either type of economy.

 

Government Debt, The Real Interest Rate, Growth and External Balance in A Small Open Economy

This paper examines the effects of government debt policies with imperfect substitutability between securities issued by different countries. It puts forward an intertemporal model of a small open economy to analyze the effects of government debt on the real interest rate, economic growth, private consumption and the balance of payments. The model is an endogenous growth, overlapping generations model with convex adjustment costs for investment, and imperfect substitutability between domestic and foreign bonds. It is shown than an increase in the government debt to output ratio causes the spread between the domestic and the foreign real interest rate to rise and the endogenous growth rate to fall. In addition, when domestic government bonds are relatively close substitutes for foreign bonds, the rise in government debt causes a temporary rise in domestic consumption, as current generations view government debt as wealth. The current account moves into deficit, the economy decumulates net foreign assets, and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output fall. When domestic government bonds are not close substitutes for foreign bonds,  the rise in government debt causes a temporary fall in domestic consumption, as the negative real interest rate effect of the rise in government debt dominates the wealth effect. In this case the current account improves and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output rise.

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Discussion Paper no. 9-13, Department of Economics, Athens University of Economics and Business

 

 

Money, Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy to analyze the effects of money, government debt and real shocks on growth, inflation and external balance. The model is an endogenous growth, overlapping generations model, with money in the utility function, convex adjustment costs for investment, and perfect substitutability between domestic and foreign bonds. It is shown that the growth rate depends only on the world real interest rate, the productivity of domestic capital, the adjustment cost parameter for investment and the depreciation rate. It does not depend on money, budgetary policies or the preferences of domestic consumers. Consumption of goods and services and external balance, in addition to the world real interest rate and the domestic productivity of capital, depend on money, budgetary policies and the preferences of domestic consumers. The model is used to analyze the full effects of real and monetary shocks. Monetary growth is not superneutral in this model, as it affects domestic consumption and the net foreign position of the economy.

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Working Paper 16-2012 Department of Economics AUEB

 

Endogenous Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy which allows for the simultaneous analysis of the determination of endogenous growth and external balance. The model assumes infinitely lived, overlapping generations that maximize lifetime utility, and competitive firms that maximize their net present value in the presence of adjustment costs for investment. Domestic securities are assumed perfect substitutes for foreign securities and the economy is small in the sense of being a price taker in international goods and assets markets. The endogenous growth rate is determined solely as a function of the determinants of domestic investment, such as the world real interest rate, the technology of domestic production and adjustment costs for investment. The endogenous growth rate is independent of domestic savings and the preferences of consumers. Given the domestic growth and investment rate, the preferences of consumers determine the current account and external balance. The model can also be used to analyze the implications of budgetary policy. The world real interest rate affects growth negatively but has a positive impact on external balance. The productivity of domestic capital affects growth positively but causes a deterioration in external balance. Government consumption and government debt affect the current account and external balance negatively, but do not affect the endogenous growth rate. This model addresses and resolves the indeterminancy problems that arise in comparable representative household endogenous growth models of small open economies.

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Working Paper 15-2012 of Department of Economics AUEB

Greece’s Sovereign Debt Crisis: Retrospect and Prospect

This paper provides an analysis and assessment of the Greek sovereign debt crisis, and examines alternative solutions to the problem. In order to put the current fiscal predicament of Greece in perspective and discuss how the Greek debt crisis might possibly be resolved, the paper first provides a detailed account of how the sovereign debt of Greece was accumulated and then stabilized relative to GDP. It then proceeds with an account of how the international financial crisis led to a de- stabilization of Greece’s sovereign debt, and with an assessment of the adjustment program currently in operation. We address the question of solvency, and whether the current program is sufficient for the resolution of Greece’s debt crisis. The paper concludes with proposals for tackling the confidence crisis and speeding up the recovery of the Greek economy.

GreeSE Paper no 54, Hellenic Observatory, London School of Economics