Endogenous fiscal dominance: expectations, political shocks and sovereign risk

Public debt in advanced economies has reached historically high levels, raising concerns about fiscal sustainability and the fiscal–monetary nexus.

Professor Paul De Grauwe, John Paulson Chair in European Political Economy, has co-authored a new discussion paper with Pasquale Foresti, which presents a behavioural New Keynesian sovereign-debt model to account for abrupt increases in sovereign spreads and episodes of self-fulfilling fiscal stress, which Standard New Keynesian models fail to do.

Abstract

"Public debt in advanced economies has reached historically high levels, raising concerns about fiscal sustainability and the fiscal–monetary nexus. Standard New Keynesian models have difficulty accounting for abrupt increases in sovereign spreads and episodes of self-fulfilling fiscal stress.We present a behavioural New Keynesian sovereign-debt model in which fiscal dominance emerges endogenously from shifts in agents’ beliefs. Agents switch between a Benign Debt Heuristic and a Fiscal Dominance Heuristic based on forecasting performance and political signals. This framework provides a tractable approach to understanding how expectations and fiscal conditions interact to shape sovereign risk in high-debt environments. Belief-driven shifts generate nonlinear and state-dependent sovereign risk premia, even when fundamentals remain broadly unchanged. We show that political disturbances can trigger fiscal dominance, that shock persistence governs its duration, and that higher public debt increases the macroeconomic impact of these episodes by shifting the economy into a more fragile fiscal-financial region. These dynamics translate into endogenous fluctuations in financial conditions and real activity, highlighting how political shocks can propagate to macroeconomic outcomes through sovereign risk channels."