In recent years maximum sustainable government debt in closed economies once again became a matter of theoretical concern (Rankin and Roffia 2003). The closed-economy framework precludes however the analysis of sustainable government debt in large, open, interdependent economies. At the present stage of international integration dramatically rising government deficits in large open OECD countries make it imperative to explore (1) limits for national government debt levels which if slightly exceeded would lead to a sudden collapse of the world economy and (2) the effects of government debt expansion below the limits on private capital accumulation (growth) and international competitiveness as measured by the real exchange rate or the (external) terms of trade. While the first topic has not been investigated so far at all, the established literature regarding the second topic (Zee 1987, Lin 1994) left the role of the net foreign asset position of the more indebted country for the terms of trade effect unresolved.

The main objectives of the present paper are thus to answer the following questions: (1) Do maximum sustainable government debt levels always exist and what happens if these limits are reached? (2) Which role play maximum sustainable government debt levels for the existence and dynamic stability of private capital labour ratios at home and abroad and how does the net foreign asset position of more indebted countries impinge on the terms of trade effect of unilateral government debt expansion?

(2) Data / Methods

Methodologically spoken, we provide a theoretical study which is to be seen as preliminary to a full-blown dynamic CGE model. We extend Rankin and Roffia’s (2003) closed economy overlapping generations’ model into a two-good, two-country setting which portrays a world economy consisting of two groups of countries characterized by their net foreign asset position. Both countries are interconnected through free trade in produced commodities and in bonds emitted by national governments. Within this model setting existence and interconnectedness of maximal national government debt levels as well as existence and dynamic stability of steady states and the transitional dynamics of private capital when government debt levels remain below the limits are analyzed. To evaluate quantitatively the effects of unilateral government debt expansion on terms of trade and capital accumulation along the transition path towards the new steady state, we utilize GAMS software.

(3) Results

In line with overlapping generations’ models without an operative bequest motive we find that maximum government debt levels for both countries exist and are negatively related. When the limits for national government debt levels are reached the world economy undergoes a saddle-node bifurcation, that is, it implodes suddenly. Moreover, if sustainable government debt is unilaterally expanded, private capital is crowded out in both countries while the terms of trade of the debt-expanding country are unaffected if capital income shares are internationally equal. If the latter differ, the terms of trade respond to the government debt shock, however, whether they rise or fall, is independent of the net foreign asset position of the more indebted country.