Working Paper: NBER ID: w4656
Authors: Joshua Aizenman
Abstract: This paper investigates the behavior of public debt in countries forming a union (as outlined, e.g., by the Maastricht treaty). We consider a federal union of states where the center has limited control over the spending patterns of the union members, and where the union members' behavior has repercussions for the future public debt. The public has preferences against higher public debt, and will oust high-debt administrations. Adverse shocks are shown to induce a regime switch from a cooperative outcome to limited cooperation, and from limited cooperation to the noncooperative outcome. While a transitory adverse shock calls for a higher public debt in the cooperative regime, the switch towards limited cooperation entails a drop in the public debt (relative to the cooperative desirable outcome). With limited cooperation further drops in income will call for a drop in public debt. If the adverse shock is powerful enough, sustaining limited cooperation may become unfeasible. A regime switch may yield nonlinearities, where the macroeconomic behavior is abruptly altered following the switch. Our model provides a tentative support for limits on public debt, needed to free the instrument of deficit financing for use in bad recessions.
Keywords: Fiscal Discipline; Public Debt; Economic Union; Maastricht Treaty
JEL Codes: H63; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse shocks (E32) | Regime switch from cooperative outcome to limited cooperation (C72) |
| Adverse shocks (E32) | Regime switch from limited cooperation to noncooperative outcome (C72) |
| Transitory adverse shock (E32) | Higher public debt in cooperative regime (H69) |
| Switch to limited cooperation (C71) | Drop in public debt relative to cooperative outcome (H69) |
| Severe adverse shocks (E44) | Unfeasibility of sustaining limited cooperation (D74) |
| Limits on public debt (H63) | Allow for deficit financing during economic downturns (E62) |