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Credit market discipline: theory and evidence.

Article Excerpt
Abstract

Popular in the academic literature and financial press, the credit market discipline hypothesis holds that credit markets, through risk premia increasing in debt level, constrain governments from borrowing and thus, impose fiscal discipline on sovereign borrowers. While several papers document rising risk premia, none have investigated the consumption response. This paper fills this gap by using data on U.S. states' risk premia from 1973-98. An optimizing model is formulated, whereby states intertemporally smooth consumption in the face of interest rates which increase with debt. Deviations from optimality are considered by allowing for governments which consume out of contemporaneous resources. In both cases, credit market discipline is rejected. Rejection is robust to sample splits based on ideology and the stringency of balanced budget requirements. (JEL E62)

Introduction

The implementation of European Monetary Unification (EMU) has reignited interest in methods which may ensure fiscal discipline among sovereign participants in a monetary union. One approach is the implementation of binding fiscal rules which seek to cap the deficits and debts of union members as percentages of GDP. Another approach suggests relying on market forces to discipline errant borrowers. According to this credit market discipline hypothesis, excessive sovereign borrowing results in a rising default premium on the government's debt, with continued borrowing ultimately resulting in the cutoff of credit. The increase in borrowing costs and the potential inability to continue borrowing exerts pressure on the government to reduce borrowing and spending. A market that successfully disciplines borrowers implies that there is no need for policy rules or other politically influenced arrangements designed to limit sovereign debt, and furthermore, that no concern need exist when such rules are broken.

Building on Stiglitz and Weiss' [1981] theoretical work which shows that the upward sloping supply curve of credit can be backward bending when current borrowing affects the probability of default, several papers have documented that a government's cost of borrowing increases nonlinearly in the amount of its outstanding debt and current deficit. For example, Capeci [1994] studies the effect of outstanding debt and current deficits on municipal borrowing costs by analyzing new issues made by New Jersey municipalities between January 1, 1975 and December 31, 1977. He finds that credit markets impose substantial penalties on municipalities that have large debt burdens, that is, a one standard deviation rise in the amount borrowed is associated with an increase of 66 points in the borrowing rate. Similarly, Goldstein and Woglom [1992] and Bayoumi, Goldstein, and Woglom [1995] use a panel of U.S. states and yield spreads over the period 1981-90 to study the effect of debt on state general obligation bond yields. Both papers find evidence of an upward sloping, backward bending credit supply curve. At the mean sample values, each percentage increase in relative debt raises the yield by 23 basis points, while at debt levels one standard deviation above the mean, the yield is raised by 35 basis points. Eaton and Gersovitz [1981] also focus on the supply of credit to sovereign borrowers and find evidence of credit rationing in poorer countries.

No investigation has been done on whether rising risk premia actually affect government consumption. This paper seeks to fill this gap. The effects of rising risk premia on government consumption are examined by using a panel data set on the risk premia charged to the U.S. states, the Chubb Relative Value Study, over the period 1973-98. This is a bigger sample of the risk premia data also used by Goldstein and Woglom [1992] and Bayoumi, Goldstein and Woglom [1995] in their investigation of the shape of the credit supply curve. A fully optimizing model of state governments is proposed whereby the states intertemporally smooth public consumption in the face of an interest rate which increases in debt level.

Note that in order for consumption smoothing to be viable, the government must be able to run deficits during bad times and surpluses during good times. Most states have balanced budget rules, which seem to preclude the possibility of smoothing by state governments. However, the effectiveness of these rules is an open question. A study by Holtz-Eakin, Rosen, and Tilly [1994] contains anecdotal evidence and examples of the ease with which state governments skirt balanced budget laws. In addition, while Bohn and Inman [1996] find that states which have regulations limiting the amount of debt have lower average deficits, Sorensen, Wu, and Yosha [1998] find that states are able to systematically smooth income shocks. Given these results, it is assumed that balanced budget rules do not prohibit states from implementing smoothing strategies. The validity of this assumption is tested in the empirical section.

Testing of credit market discipline is based on the first order condition for optimization. The intertemporal public consumption Euler equation links the growth rate of public consumption and the interest rate, which is...

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