Evaluating the sustainability of Italian public finances

Are Italy’s primary-surplus policies compatible with the sustainability of government debt? We address the question by examining historical budget data in post-unification Italy, from 1861 to 2016. Controlling for temporary output, temporary spending and world war-time periods in assessing whether primary surpluses significantly reacted to changes in debt, we find the following results: (i) the hypothesis of nonlinearity in the surplus-debt relationship significantly outperforms the hypothesis of linearity; (ii) there exists a threshold level in the debt-GDP ratio, approximately equal to 105 percent, above which Italian fiscal policy makers are concerned with corrective actions to avoid insolvency; (iii) the robustly positive reaction of primary surpluses to debt beyond the trigger point ensures fiscal sustainability.     

Impacts of Monetary, Fiscal and Exchange Rate Policies on Output in China: A Var Approach

Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.JEL Classifications: E5, F4, H6     

Government debt spillovers in a monetary union

This paper presents estimates of the impact of debt issued by one government in a monetary union on the yields of the bonds issued by other governments in the union. These debt spillovers may occur if there is a risk of monetary accommodation, implicit or explicit inter-jurisdictional bailout provisions, or interdependent revenues. The analysis empirically distinguishes between two channels through which debt spillovers may affect bond yields: currency depreciation risk and default risk. Data on the yields of individual Canadian provincial government bonds for the period 1983–2005 are employed. No evidence is found of debt spillovers between provinces, but a one percentage point increase in the central government's debt to GDP ratio raises the yield on provincial government bonds by 4.2 basis points—2.9 basis points by increasing the expected depreciation rate of the Canadian dollar and 1.3 basis points by raising the risk of provincial government default. These results imply that a rise in the Canadian central government debt to GDP ratio from 0.25 to 0.58, equivalent to the rise that occurred between 1983 and 1995, would lead to an increase in provincial government bond yields of approximately 140 basis points.     

Policy uncertainty and aggregate fluctuations

This paper estimates the impact on the US economy of four types of uncertainty about (i) government spending, (ii) tax changes, (iii) public debt, and (iv) monetary policy. Uncertainty about government debt has a large and persistent effect on output, consumption, investment, consumer confidence, and business confidence. Uncertainty about tax changes also has detrimental consequences for real activity but the effect of spending and monetary policy uncertainty appears to be small. About 25% of output fluctuations are accounted for by policy uncertainty, with government debt making the largest contribution at longer horizons.     

Dynamics of fiscal financing in the United States

General equilibrium models that include policy rules for government spending, lump-sum transfers, and distortionary taxation on labor and capital income and on consumption expenditures are fit to US data under rich specifications of fiscal policy rules to obtain several results. First, the best-fitting model allows many fiscal instruments to respond to debt. Second, responses of aggregates to fiscal policy shocks under rich rules vary considerably from responses where only non-distortionary fiscal instruments finance debt. Third, in the short run, all fiscal instruments except labor taxes react strongly to debt, but long-run intertemporal financing comes from all components of the government’s budget constraint. Fourth, debt-financed fiscal shocks trigger long-lasting dynamics; short-run and long-run multipliers can differ markedly.     

The weighted average cost of capital is not quite right: Reply to M. Pierru

In this journal [Miller, R. A. (2009). The weighted average cost of capital is not quite right. The Quarterly Review of Economics and Finance, 49, 128–138], I argued that the standard WACC formula is inadequate in most circumstances to reward stockholders and bondholders where the necessary cash flows are calculated separately to exactly cover the respective costs of capital. Axel Pierru [2009. ‘The weighted average cost of capital is not quite right’: A comment. The Quarterly Review of Economics and Finance, 49, 1219–1223] observes correctly that my assumed repayment schedules (equal periodic payments to bondholders; similarly for stockholders) imply a temporal drift in the debt (or leverage) ratio; he would recalculate the WACC annually. He proposes an alternative calculation of the repayment schedules under the constraint of a constant debt ratio. Here I suggest three additional possible repayment schedules; in general repayment schedules determine the drift in the debt ratio. However, the expected repayment schedules are established at the time the project is accepted and financed, hence the relevant debt ratio is that which exists at that time. The WACC for a specific project need not (and should not) be recalculated for that project throughout its financial life when that project has already been accepted and financed.     

Debt stabilization games in the presence of risk premia

As a result of the recent financial crisis and the ensuing economic recession, fiscal deficits have soared in many OECD countries. As a consequence, government debt has been on the rise again after a period of stable or declining government debt. In this paper we analyze debt stabilization in a country that features endogenous risk premia, imposed by financial markets that evaluate the probability of debt default by governments. Endogenous risk premia arise by assuming, e.g., simple linear relations between risk premia and the level of debt. As a result the real interest rate on government debt can be written as a constant (measuring the risk-free real interest rate corrected for real output growth) plus an endogenous risk premium that depends on the debt level. We bring such an endogenous risk premium into Tabellini (1986) model and analyze the impact of it. This gives rise to a non-linear differential game. We solve this game for both a cooperative setting and a non-cooperative setting. The non-cooperative game is solved under an open-loop information structure. We present a bifurcation analysis w.r.t. the risk premium parameter.     

When Does Government Debt Crowd Out Investment?

We examine when government debt crowds out investment for the US economy using an estimated New Keynesian model with detailed fiscal specifications and accounting for monetary and fiscal policy interactions. Whether investment is crowded in or out in the short term depends on policy shocks triggering debt expansions: higher debt can crowd in investment for cutting capital tax rates or increasing government investment. Contrary to the conventional view, no systematic relationships between real interest rates and investment exist, explaining why reduced‐form regressions are inconclusive about crowding out. At longer horizons, distortionary financing is important for the negative investment response to debt. Copyright © 2013 John Wiley & Sons, Ltd.     

Myopic governments and welfare-enhancing debt limits

This paper studies welfare effects of a soft borrowing constraint on sovereign debt. The constraint is modeled as a proportional fine per unit of debt in excess of a specified reference value, resembling features of the Stability and Growth Pact. Sovereign debt is the result of myopic fiscal policy. It reduces welfare in the absence of lump-sum taxes. The paper shows that the borrowing constraint enhances welfare by reducing long run debt. In an economy calibrated to a generic OECD country, the maximum attainable welfare gain of debt consolidation, which is induced by imposing the optimally parameterized constraint, amounts to 0.5% in terms of consumption. The short run welfare costs of the constraint, which arise from restricting the use of debt to smooth taxes, are quantitatively negligible.     

A remark on the fiscal theory of price determination

The fiscal theory of price determination asserts that the price level is determined by the ratio of nominal public debt to the present value of real primary surpluses. To show its fragility, we describe a simple monetary economy with an infinitely lived real productive asset. Under the hypotheses of the fiscal theory, speculative bubbles occur at equilibrium, thus leading to an indeterminate price level.     

Fiscal policy,debt constraint and expectations-driven volatility

Imposing some constraints on public debt is often justified regarding sustainability and stability issues. This is especially the case when the ratio of public debt over GDP is restricted to be constant. Using a Ramsey model, we show that such a constraint can however be a fundamental source of indeterminacy, and therefore, of expectations-driven fluctuations. Indeed, through the intertemporal budget constraint of the government, income taxation negatively depends on future debt, i.e. on the expected level of production. This mechanism ensures that expectations on the future tax rate may be self-fulfilling. We show that this is promoted by a larger ratio of debt over GDP.     

A remark on the fiscal theory of price determination

The fiscal theory of price determination asserts that the price level is determined by the ratio of nominal public debt to the present value of real primary surpluses. To show its fragility, we describe a simple monetary economy with an infinitely lived real productive asset. Under the hypotheses of the fiscal theory, speculative bubbles occur at equilibrium, thus leading to an indeterminate price level.     

Public versus private provision of liquidity: Is there a trade-off?

To what extent is public debt private liquidity? Much policy advice given in the aftermath of the financial crisis rests on the assumption that increasing public debt relaxes borrowing constraints of private households. This is the case for ad-hoc debt limits, which are exogenous to public policy. Instead, if debt limits are fully endogenous, as e.g. in the case of the natural borrowing limit, public debt has no impact. We assume that borrowing limits arise because of limited contract enforceability and are therefore determined as equilibrium outcomes. Using an incomplete markets economy in which households are subject to uninsurable earnings shocks, we show that public debt provides some liquidity, but less so than it would if constraints were imposed ad-hoc. We show that generating borrowing constraints as an equilibrium outcome substantially alters the answers to other important questions, such as for the welfare effects of government debt or its impact on real economic activity.     

Government debt,learning and the term structure

Does a change in the public׳s holdings of government debt affect the term structure of interest rates? Empirical analysis using a VAR model indicates that a rise in these holdings of the real debt-to-GDP ratio increases both the three-month and ten-year U.S. nominal yields in a statistically significant manner. The maturity composition of debt is also found to matter: innovations in holdings of long-term debt affect the term structure, while increases in short-term debt affect inflation expectations. These effects of changes in holdings of debt on the yield curve can be derived in a general equilibrium model in which the government issues exponentially-maturing riskless debt, financed by lump-sum taxes, and the optimizing agents are adaptive learners. On calibrating the average maturity of debt in the model to match that of U.S. Treasury debt since the 1980s, I find that positive innovations in government debt lead to increases in asset yields. This is because agents do not learn the principle of Ricardian equivalence exactly, and perceive increases in holdings of government bonds as a rise in their net wealth. Imposing rational expectations on the agents eliminates this channel, and changes in holdings of government debt have no effect on yields. The learning model also implies that as the real debt-to-GDP ratio increases, and the average maturity of debt becomes longer, the agents become less likely to learn that Ricardian equivalence holds.     

The Cost Effectiveness of the UK's Sovereign Debt Portfolio*

This paper provides a recursive empirical analysis of the scope for cost minimization in public debt management when the debt manager faces a given short‐term interest rate dictated by monetary policy as well as risk and market impact constraints. It simulates the ‘real‐time’ interest costs of alternative portfolios for UK government debt between April 1985 and March 2000. These portfolios are constructed using forecasts of return spreads based on a recursive modelling procedure. While we find statistically significant evidence of predictability, the interest cost savings are quite small when portfolio shares are constrained to lie within historical bounds.     

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.     

Prudence and Pragmatism in the Fiscal Stance

In this article, Simon Price argues that the government is pursuing a remarkably conservative fiscal policy. Not only has demand management been left almost entirely to the MPC, but since 1997 spending has been held down while the overall tax burden has been raised. Consequently, the relative size of the national debt is declining at a rapid rate. There are rules that are intended to govern debt policy, but they are based on less sound principles than the government argues, and may be inconsistent. Oddly, despite the emphasis on these rules, the government has announced a path for spending that makes it clear that it is in fact planning not to follow them. The government may be planning to reduce the national debt at an excessive rate. This may make sense in the short run, but is more problematic in the medium to long term. This is not to say fiscal policy should be immediately relaxed; the current low levels of private sector saving may well justify a temporarily tight fiscal stance.     

The effect of corporate governance on credit ratings: Evidence from China's bond market

This paper examines the association between firms’ corporate governance and credit ratings (both bond ratings and issuer ratings) in China. In addition to considering the financial attributes of bond issuers, we ask to what extent do credit rating agencies consider the corporate governance attributes of issuers? In concept, bondholders are concerned with the financial effects of how corporate governance resolves the agency conflicts between bondholders and managers, majority and minority shareholders, and shareholders and bondholders. We find that corporate governance affects bond issuer credit ratings in China. After controlling for firms’ financial attributes, we find that issuer ratings are positively related to dual‐listing, whether the firm is a state‐owned enterprise, the ownership of the second to the tenth largest shareholder; and negatively related to the relative scale of audit fees. We attribute the positive association between dual‐listing and credit rating to higher quality and transparency of information reported by the dual‐listed firm. The value to bondholders of the implicit government guarantee of debt payments more than offsets the negative association between firm value and being an SOE. Bond rating agencies expect that the change in agency costs with a reduction in the ownership of the largest shareholder benefits bondholders. To credit rating agencies, the scale of audit fees (relative to total assets of the accounting firm) signals interest binding between the client firm and the accounting firm that threatens the independence of auditing and the quality of financial reporting. We also find that bond‐specific attributes: collateral and issue size, are positively related to bond credit ratings.     

Banking in computable general equilibrium economies

In this paper we develop a computable general equilibrium economy that models the banking sector explicitly. Banks intermediate between households and between the household sector and the government sector. Households borrow from banks to finance their purchases of houses and they lend to banks to save for retirement. Banks pool households' savings and they purchase interest-bearing government debt and non-interest-bearing reserves. We use this structure to answer two sets of questions: one normative in nature that evaluates the welfare costs of alternative monetary and tax policies, and one positive in nature that studies the real effects of following a procyclical interest-rate policy rule.     

Did covenants distort risk signals from bank subordinated debt yields before the financial crisis?

Restrictive covenants on bank debt require a bank to take or refrain from specific actions that affect the riskiness of that debt. Although covenants all but disappeared in the 1990s, they re-emerged after 2004 with an increase in bank risk leading up to the financial crisis. Subordinated debt yields potentially enable better risk monitoring by supervisors, but covenants can shift risk from bondholders to stockholders without reducing overall bank risk. This can distort the risk signal used by market participants to discipline excessive risk taking. Because covenants are endogenous and increase during periods of bank stress, the yield signal is dampened the most precisely when regulators most need accurate risk monitoring.