Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States
Bayoumi, Tamim, Goldstein, Morris, Woglom, Geoffrey, Journal of Money, Credit & Banking
There has been considerable theoretical interest in describing how rational lenders may respond to imperfect information by rationing credit to borrowers.(1) Much of this literature identifies the resulting credit constraints with a market failure (see, in particular, Jaffee and Russell 1976). Recently, however, it has been argued that default premia and credit constraints can play a more positive role in disciplining irresponsible, sovereign borrowers.
This more optimistic view of the effects of credit constraints has been called the market discipline hypothesis, and this hypothesis has played a key role in the debate on the most effective way to restrain fiscal policy adventurism in a European Monetary Union (Bishop, Damrau, and Miller 1989). An important aspect of the market discipline hypothesis is an assumed nonlinear relationship between yields and debt variables. In particular, the advocates of market discipline assume that yields will rise smoothly at an increasing rate with the level of borrowing, thereby providing the borrower with an incentive to restrain excessive borrowing. If these incentives, however, prove ineffective, the credit markets will eventually respond by denying the irresponsible borrower further access to credit, and the irresponsible borrower will be credit constrained.
This paper draws on a unique set of survey data on municipal bond yields for U.S. states to shed light on the theory of credit constraints in general and, to test the market discipline hypothesis by identifying the nonlinear supply curve faced by risky sovereign borrowers.
The next section of this paper provides a more detailed discussion of the market discipline hypothesis and of the debate on the appropriate mechanism for reining in irresponsible fiscal policy behavior in a European Monetary Union. The second section develops a simple theory of lending to sovereign borrowers, while the third section discusses the empirical specification of the model and describes a previously unused data source, which we believe is uniquely well suited for measuring default premia in the yield spreads of U.S. state general obligation bonds. The fourth section presents our results, and the final section provides our conclusions. To anticipate our results, we find strong support for a nonlinear specification of the supply curve, which is consistent with the market discipline hypothesis. Our point estimates imply that at the mean level of debt in our sample the promised yield rises by about 23 basis points per percentage point of trend output increase in debt. But at debt levels one standard deviation above the mean, the increase in yields rises to over 35 basis points, and our estimates imply credit may become rationed at debt levels about 25 percent above the highest debt level in our sample.
1. FISCAL COORDINATION AND EUROPEAN MONETARY UNIFICATION
It is widely accepted that participation in a currency union is inconsistent with independence in the conduct of monetary policy. Indeed, in the negotiations leading to the Maastricht Treaty on economic and monetary union (EMU) in Europe, much attention was devoted both to the establishment of a central monetary authority and to securing a mandate for that institution that would give primacy to the goal of price stability. In this sense, there would appear to be an emerging consensus about how to constrain or "discipline" monetary policy.
Less settled at this stage is what constraints, if any, should be placed on national fiscal policies in a currency union. At least three distinct approaches to disciplining fiscal policy have been put forward in the literature. One view, echoed in the Delors Report, is that binding fiscal rules represent the preferred solution to the problem. In this connection, the Maastricht Treaty includes ceilings on the ratios of government debt (60 percent) and the fiscal deficit to Gross Domestic Product (3 percent) as criteria for entry into European Economic and Monetary Union, as well as prohibitions on monetary financing and bailing out of budget deficits. …