Fiscal Rules and Market Discipline

Fiscal rules have proliferated as a way to limit public debt. Rules aim to impose fiscal discipline on governments that might be otherwise present-biased. However, lenders also discipline government borrowing through a market mechanism, with excessive debt penalized with higher interest rates. In this paper, we study the interaction between fiscal rules and market discipline in limiting government borrowing. We do so in a sovereign borrowing model with asymmetric information about governments’ propensity to over-borrow and default. Governments may signal their fiscal rectitude by showing fiscal restraint and this can lead not only to over-borrowing as in traditional models, but also to under-borrowing, as governments attempt to signal their fiscal responsibility. In addition to their traditional role of restraining present-biased governments, fiscal rules also make signalling more difficult and may have the perverse effect of forcing prudent governments to save even more excessively than otherwise, or alternatively hamper their ability to signal their rectitude entirely. Fiscal rules restrain impatient governments but penalize prudent governments. An optimal fiscal rule balances these trade-offs and will be binding at times, but will never be so tight as to naïvely push governments to “do the right thing”.