DP18007 Debt ceilings with fiscal intransparency and imperfect electoral accountability
Motivated by the recent debate about the EU fiscal framework, we analyse public debt ceilings in a political-economy model with uncertainty about both the type of policymaker (benevolent or selfish) and the state of the economy (good or bad). Pooling, hybrid and separating equilibria may exist. The presence of elections generates disciplining and selection effects, of which the relative importance differs across these equilibria. Shifts in the debt ceiling may lead to switches in the prevailing type of equilibrium, thereby inducing jumps in expected welfare. The optimal debt ceiling trades off the implied distortion in the intertemporal allocation of resources under a benevolent policymaker against excessive debt creation under a self-interested policymaker so as to finance diversion of resources for private use. Increased transparency in terms of voters learning with a higher probability the state of the economy before casting their vote affects neither the optimal ceiling nor expected welfare. If instead increased transparency allows for imposing state-contingent debt ceilings, for instance monitored by an independent fiscal institution, welfare may be improved. We identify the circumstances under which it is optimal to make debt ceilings state-contingent. State-contingent ceilings induce more frequent pooling, resulting in less excessive debt creation. The potential benefits of state-contingency support the greater role that recent European Commission proposals assign to the national independent fiscal institutions and the differentiation in debt reduction paths of EU Member States.