Ebook The Time-Consistency of Government Debt and Institutional Restrictions on the Level of Debt
Since Kydland and Prescott (1977)’s advocacy for rules rather than discretion, there has been a lot of debate about how much we should tie the hands of the policymaker in order to reduce or eliminate time-inconsistency problems. In this paper we study the time inconsistency problem of government debt. As earlier literature illustrates, governments are tempted to default on and to devaluate (through the manipulation of the interest rate) their debt obligations. Moreover, the higher is the level of government debt the larger the government’s temptation. Is then desirable to impose an institutional constraint on the amount of government debt?
Many countries have recently adopted limits on government debt. There are two main arguments in favor, namely, these debt limits may lessen time-inconsistency problems; and they may help prevent excessive government spending. The main argument against is that they may reduce the flexibility of the government in response to shocks. This paper attempts to isolate the effect of debt limits on the time-inconsistency problem of government debt.
We consider an environment similar to that of Lucas and Stokey (1983), a deterministic economy where a benevolent government must decide how to finance the government spending through taxes on labor income and through the issue of debt. In the economy with commitment, debt limits are generally not desirable. If binding, they limit the ability of the government to smooth taxes over time and, hence, reduce welfare. In the economy without commitment, the government is tempted to default and to manipulate the interest rate of the outstanding debt obligations. We assume that a default on debt payments entails a direct cost to the economy, more precisely, a productivity fall. In this setup, we assume that the society can credibly impose a limit on government debt and explore whether such institutional restriction is desirable.
To answer this question, we focus on the whole set of sustainable equilibria rather than the best sustainable equilibrium. We do so because the implementation of one sustainable equilibrium out of a large set of sustainable equilibria requires a considerable coordination of beliefs by private individuals and such coordination is not under the control of the government.
We apply the APS method developed by Abreu, Pearce and Stacchetti (1990) and extended to dynamic policy games by Chang (1998), Phelan and Stacchetti (2001) and Sleet (1997) to our economy. We first study the economy without any restrictions on the level of government debt. There we find that the worst sustainable equilibrium is a balanced budget with or without default. This is so because the government can always deviate and unilaterally impose a balanced budget. Next, we consider an institutional restriction on the level of government debt. We find that a debt limit changes the set of sustainable equilibria. In particular, a debt limit can make default not longer sustainable. Moreover, since the worst sustainable equilibrium provides now higher welfare, a debt limit may make some good equilibria, e.g. the Ramsey outcome, not sustainable. Thus, our findings capture what once Rogoff (1987) pointed out, we obtain that debt limits have the “danger of throwing out the baby (any good reputational equilibria) with the bathwater”.
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