Sovereign debt, fiscal policy, and macroeconomic instability

In this paper we study the interplay between government debt, fiscal policy, and macroeconomic instability. We consider a small open economy where the government maximizes spending in order to be reelected, facing endogenous borrowing constraints and a conditionality requirement imposed by creditors designed to increase productivity.

We show that the choice of the tax rate rule critically determines steady state properties and the dynamics of the economy. Indeed, steady state multiplicity, which is necessary for the emergence of global indeterminacy, is more likely the greater the response of the tax rate rule to income is. Also, in the case of a Cobb-Douglas production function, where we have at most two steady states, if the tax rate is sufficiently procyclical and productive externalities are not too small, the economy exhibits both local and global indeterminacy. This means that the economy will be subject to both local and global endogenous fluctuations driven by self-fulfilling volatile expectations. In contrast, if the response of the tax rate to the cycle is not too positive, regardless of the strength of the productive externality, local and global indeterminacy do not emerge, as the high output steady state is either unique and stable or it is saddle-stable and a global attractor. We conclude that by avoiding sufficiently procyclical tax rate rules the government guarantees convergence to the high output steady state, stabilizing the economy against local or global instability due to volatile expectations. Note that the government always prefers the steady state associated with the highest level of output, which also corresponds to higher levels of government spending. Therefore it follows that in the presence of borrowing constraints, governments should not adopt tax rate rules that are too procyclical in order to maximize spending and stabilize the economy.