On the Need for Fiscal Discipline in a Union, Issue 4656
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.
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