DP8001 Government Debt Threshold Contracts
Politicians tend to push the amount of public debt beyond socially desirable levels in order to increase their reelection chances. We develop a model that provides a new explanation for this behavior: office holders undertake debt-financed public projects, but postpone the timing of part of the output to the next term. This makes it difficult to replace them. As a consequence, the office-holders' reelection chances rise -- as does public debt. As a potential remedy for this inefficiency, we allow candidates for public office to offer government debt-threshold contracts. Such a contract contains an upper limit for government debt and the sanction that an office-holder violating this limit cannot stand for reelection. We show that such competitively-offered contracts contain low debt levels that limit debt financing and improve the citizens' welfare. When negative macroeconomic events occur, government debt contracts may be violated, and such shocks are stabilized.
