Limits for National Debt in a World Economy with Internationally Differing Growth Rates

US Federal Reserve chairman Ben Bernanke recently called for quick and decisive steps to rein in the exploding US budget deficit, warning failure to act could result in a serious crisis (AFP, October 5^th 2010). Bernanke’s warnings are the most prominent among a series of concerns with respect to sustainability of national debt especially in advanced economies (IMF 2009, 2010). In the aftermath of the great recession 2007-2009 these economies suffer from low GDP growth rates, exploding government deficits and still large external imbalances. In contrast, population rich developing countries like China and India enjoy high GDP growth rates and external surpluses. As a consequence, there is a growth-rate and external-balance divide running through the world economy which makes it imperative to explore limits for national debt respectively sustainability of government debt ((Neck and Sturm 2008)) in an intertemporal equilibrium model of two interdependent economic areas with differing growth rates. While Farmer and Zotti (2010) and Farmer (2010) investigate limits for national debt in a two-country overlapping generations (OLG) model with internationally identical growth rates, there does not exist a comparable model of the world economy with internationally differing growth rates. There are thus two main objectives of the underlying paper: first to explore the existence and determinants of ‘maximum sustainable’ (Rankin and Roffia 2003) debt levels in a two-country overlapping generations’ model with significantly differing natural growth rates. Secondly, the effects of fiscal retrenchment in advanced economies on private capital accumulation and the real exchange rate of both groups of countries will be investigated.