Debt Policy Rules in an Open Economy

• Author: NORITAKA MAEBAYASHI,KEIICHI MORIMOTO,KOICHI FUTAGAMI,TAKEO HORI
• Date: 01 February 2017
• DOI: http://doi.org/10.1111/jpet.12197
• Published date: 01 February 2017

DEBT POLICY RULES IN AN OPEN ECONOMY

KEIICHI MORIMOTO

Meisei University

TAKEO HORI

Tokyo Institute of Technology

NORITAKA MAEBAYASHI

The University of Kitakyushu

KOICHI FUTAGAMI

Osaka University

Abstract

In a small open economy model of endogenous growth with public cap-

ital accumulation, we examine the effects of a debt policy rule under

which the government must reduce its debt–GDP ratio if it exceeds the

criterion level. To sustain public debt at a finite level, the government

should adjust public spending rather than the income tax rate. The

long-run debt–GDP ratio should be kept sufficiently low to avoid equi-

librium indeterminacy. Under sustainability and determinacy, a tighter

(looser) debt rule brings welfare gains when the world interest rate is

relatively high (low).

1. Introduction

Discretionary fiscal policies during the 2008–2009 world crisis resulted in serious in-

creases in government debt in the Euro area. In 2011, the average debt–GDP ratio in

the Euro area reached 88% of GDP, some 20 percentage points higher than at the start

of the crisis in 2007. Public debt as a share of GDP in Greece equaled 166.1% in 2012.

Debt–GDP ratios in Italy, Ireland, and Portugal also exceeded 100%. These weak fiscal

Keiichi Morimoto, Department of Economics, Meisei University, 2-1-1 Hodokubo, Hino, Tokyo

191-8506, Japan (keiichi.morimoto@meisei-u.ac.jp). Takeo Hori, Department of Social Engi-

neering, Tokyo Institute of Technology, 2-12-1, Ookayama, Meguro-ku, Tokyo 152-8552, Japan

(hori.t.ag@m.titech.ac.jp). Noritaka Maebayashi, Faculty of Economics and Business Administration,

The University of Kitakyushu, 4-2-1 Kitagata, Kokura Minami-ku, Kitakyushu, Fukuoka 802-8577, Japan

(non818mn@kitakyu-u.ac.jp). Koichi Futagami, Graduate School of Economics, Osaka University,1-7

Machikaneyama, Toyonaka, Osaka 560-0043, Japan (futagami@econ.osaka-u.ac.jp).

We would like to thank Luca Agnello, Tomohiro Hirano, Nobuhiro Kiyotaki, Ryuichiro Murota,

Yoshiyasu Ono, Josef Schroth, Takayuki Tsuruga, Stephan Turnovsky, Tuan Khai Vu, Akira Yakita,

Cheng-Chen Yang, and the participants at the 2013 Asian Meeting of the Econometric Society,the 2013

European Meeting of the Econometric Society, and other conferences for their helpful comments and

suggestions. This study was conducted while the second author was in Aoyamagakuin University. Weare

responsible for any remaining errors.

Received June 30, 2014; Accepted November 3, 2015.

C2016 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 19 (1), 2017, pp. 158–177.

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Debt Policy Rules 159

conditions raised doubts about these countries’ abilities to finance their increased debt.

As a response to the crisis, the EU has introduced strong fiscal consolidations under the

surveillance of the European Commission. Overall public deficits were reduced thanks

to expenditure cuts, especially lower public investments, as stated in public finances in

EMU (European Commission 2012).1According to the Stability and Convergence Pro-

grammes submitted to the Commission and Council in Spring 2012, EU Member States

plan to base further fiscal consolidation on expenditure cuts that include reductions

in public investment. According to the debt reduction benchmark introduced by the

reform of the Stability and Growth Pact (SGP), the so-called “Six-Pack,” in December

2011, Member States whose current debt-to-GDP ratio is above the 60% threshold have

to reduce the distance to 60% by an average rate of one-twentieth per year.2It is impor-

tant to investigate the effects of the debt-reduction rule proposed by the SGP under its

requirements.

Some authors have examined the effects of such a debt-reduction rule. In an en-

dogenous growth model whose growth engine is the flow of public service as in Barro

(1990), Futagami, Iwaisako, and Ohdoi (2008) investigate the effects of a government

bond-issuance rule that requires the government to reduce its debt at a steady pace if its

debt is beyond the criterion level. Maebayashi, Hori, and Futagami (2013, forthcoming)

use an endogenous growth model whose engine of growth is public capital accumula-

tion to study the same issue. These authors provide interesting results, but their inves-

tigations are confined to closed economies; accordingly, transactions in foreign capital

markets are removed. In reality, both the government and private sector can borrow

and lend their assets in the foreign capital market. Countries holding large levels of

debt such as Greece, Italy, Ireland, and Portugal hold large external debt as well. This

shows the significance of studying the debt policy rule described here in a model of an

open economy.

For our purpose, we consider an endogenously growing small open economy where

the government adopts a debt-reduction rule. As in Futagami, Morita, and Shibata

(1993) and Turnovsky (1997), public capital accumulated through public investment

has positive effects on private goods production. The government finances its spending

on public investment by imposing a tax on income and by issuing bonds. Public bond

issuance is under the restriction of the same debt policy rule as that in Futagami et al.

(2008). We consider two types of public finance budget regimes. In budgetary regime I,

if the debt–GDP ratio exceeds the criterion level, the government adjusts its expenditure

with a fixed tax rate to reduce this ratio. In budgetary regime II, if the debt–GDP ratio

exceeds the criterion level, the government controls the tax rate to reduce its debt with

a fixed expenditure ratio. In both regimes, the debt–GDP ratio tends to the criterion

level in the long run. The criterion level can be considered as the long-run debt–GDP

ratio.

In budgetary regime I, there exists a unique steady-state equilibrium. The long-run

debt–GDP ratio is a crucial determinant of the steady-state stability and equilibrium

(in)determinacy. When the long-run debt–GDP ratio is sufficiently low, the steady state

is saddle-stable and hence exhibits equilibrium determinacy. However, if the govern-

ment sets a high criterion debt–GDP ratio, equilibrium indeterminacy arises because

1In the Euro area, the average general government deficit fell from 6.2% of GDP in 2010 to 4.1% of

GDP in 2011.

2The Maastrichit Treaty asks EU countries to keep their deficit and debt levels below 3% and 60%,

respectively, to ensure compliance with budgetary discipline.