Collateral, Liquidity and Debt Sustainability

We study Markov‐perfect optimal fiscal policy in an economy with financial frictions and sovereign default in the form endogenously determined haircuts on outstanding debt. Government bonds facilitate tax smoothing but also provide collateral and liquidity services that mitigate financial frictions. A debt Laffer curve exists, which induces the government to issue bonds to a point where marginal debt has negative welfare effects. Debt positions in the order of magnitude of annual output remain sustainable despite the option to default. When default happens, liquidity on the bond market is impaired, which can trigger extended periods of recurrent haircuts.