Credit market discipline: Theory and evidence

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 requirments.