I study dynamic optimal fiscal rules in a supranational setting in which national governments with quasi-hyperbolic preferences are subject to privately observed idiosyncratic shocks. In this context, fiscal rules aim at striking a balance between flexibility to react to shocks, and commitment to avoid excessive government spending. I compare optimal rules in two different environments: one in which the supranational authority is allowed to transfer resources across countries (i.e. a fiscal union) and one in which transfers are forbidden. I find that optimal fiscal rules can be implemented as deficit limits and are complemented with a combination of grants and loans in a fiscal union. All instruments are debt-contingent: higher public debt contemporaneously tightens deficit limits and reduces the entity of both transfers and credits. Welfare gains from setting up a transfer system are positive, but vanish in the limit case in which governments only care about their own consumption. I present a sample calibration of the model using EU data. Optimal deficit limits are not far from Maastricht 3%; member countries under extreme distress receive help in the form of grants and loans; grants account for 30% of the overall financial help and are at most 4.5% of GDP.
(Joint with Facundo Piguillem & Liyan Shi)
It is widely believed that governments tend to overaccumulate debt, which gives rise to the need for fiscal rules. This paper studies the optimal fiscal and default rules when governments can default on their debt obligations. We build a continuous-time model that encompasses the standard rationale for debt overaccumulation: hyperbolic discounting and political economy frictions. In addition, governments are subject to taste shocks, which makes spending optimally random. Since shocks are private information, there is a trade-off between rules and discretion. We derive the optimal fiscal rules which are debt-dependent only when default is possible. Depending on the severity of the spending bias and the cost of default, the optimal fiscal rules range from strict debt limits, complemented by strong deficit limits, to the absence of all rules. In intermediate cases, debt-dependent deficit limits must be complemented with default rules, with some areas where default is banned and others where default is mandatory.
(Joint with Facundo Piguillem)
We study the optimal trade-off between commitment and flexibility in a model in which governments are present-biased toward spending and have private information on the state of the economy. Importantly, we introduce stochastic government turnover. The model decomposes the present-bias in different components: the fundamental political friction – captured by hyperbolic discounting; the overall uncertainty in the economy; and the relative relevance of political turnover versus business cycle fluctuations. Fiscal rules are found to be stricter when insurance needs are low, the present bias is high and government turnover is frequent.