Fiscal Rules and Discretion with Risk of Default

Chiara Felli, Facundo Piguillem and Liyan Shi

No 16211, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We study optimal fiscal rules when present-biased governments can default on their debt. Beyond their tendency to overaccumulate debt, they exhibit biases in default incentives. Depending on the severity of the bias and the cost of default, governments may either over-default, inefficiently defaulting at low debt, or under-default, retaining excessively high debt. The latter arises from a "clean-slate externality": governments fail to internalize the future benefits of offloading debt. Balancing the commitment to not overspend with the flexibility to react to shocks, it is optimal to complement spending rules with default rules that either forbid or force default.

Keywords: Spending bias; Fiscal rules; Government debt; Sovereign default (search for similar items in EconPapers)
JEL-codes: E6 E62 H1 H6 (search for similar items in EconPapers)
Date: 2021-06
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