We use a sovereign default model developed by Hatchondo et al. (2015) to study the implications of adopting constitutional debt limits.
It can be shown, that for a benevolent government issuing long-term debt it is welfare-enhancing to introduce credible fiscal rules to mitigate the so called "debt dilution" problem. By calibrating the theoretical model to Slovak data, we estimate the optimal (net) debt brake threshold at 48 percent of the mean annual output. Compared to a norule economy, the introduction of a fully-credible debt limit represents a substantial decrease in average sovereign spreads (50 basis points). In the empirical part of the paper we find that the introduction of the constitutional Fiscal Responsibility Act in Slovakia in 2011 might have helped to lower sovereign spreads compared to euro area peers by 20-30 basis points.
Keywords: sovereign default risk, debt dilution, fiscal rules, debt limits
JEL Classification: H1, H63, H8