It is widely accepted that participation in a currency union, such as that being considered in Europe, is inconsistent with independence in the conduct of monetary policy. Less settled at this stage is what constraints, if any, should be placed on national fiscal policies in a currency union. Several distinct approaches disciplining fiscal policy have been used in the literature on EMU. In Discussion Paper No. 1088, Research Associate Tamim Bayoumi, Morris Goldstein and Geoffrey Woglom draw on a unique set of survey data on municipal bond yields for US states to shed light on the theory of credit constraints in general and, in particular, to test the market discipline hypothesis by identifying the non-linear supply curve faced by risky sovereign borrowers.

They find strong support for a non-linear specification of the supply curve, which is consistent with the market discipline hypothesis. Their point estimates imply that at the mean level of debt in the sample, the promised yield rises by about 23 basis points per percentage point increase in debt as a ratio of output. But at debt levels one standard deviation above the mean, the increase in yields rises over 35 basis points. Their estimates imply credit may become rationed at debt levels about 25 per cent above the highest debt level in the sample. These results are broadly consistent with the optimistic view of the market discipline hypothesis. Credit markets appear to provide incentives for sovereign borrowers to restrain borrowing. These incentives seem to be imposed gradually at first, but eventually yield spreads rise in a steep, non-linear way.

Do Credit Markets Discipline Sovereign Borrowers? Evidence from US States
Tamim A Bayoumi, Morris Goldstein and Geoffrey Woglom

Discussion Paper No. 1088, January 1995 (IM)