Debt as a Countercyclical Fiscal Tool

Abstract

This chapter builds on existing literature, in particular Robert Barro’s “transitory income and government expenditure” theory, and formulates a model for the countercyclical use of long-term full faith and credit debt by state governments to finance infrastructure. The model incorporates long-term debt into budgetary policy, bringing into consideration debt capacity, purposes and security of debt, as well as equity issues. The proposition is to retire debt in boom years in order to preserve debt capacity and reduce borrowing costs and then incur debt at a lower interest rate in bust years in order to help maintain state government’s service provision and pave the way for recovery. The chapter conducts several empirical tests. First, do states in aggregate use debt pro- or countercyclically? Second, what factors determine the cyclical patterns in states’ use of debt? Third, will the proposed optimal path of debt issue and retirement be applicable? And what may be the effects of this proposition? My results show that overall states do not tend to use debt against the economic cycle; however, I obtain some weak evidence that at least some states have adopted countercyclical debt policies. Finally, I simulate the effects of the proposed optimal debt policy with New York state; calibration shows that such a policy could have rendered the state a much better situation to encounter the Great Recession. Findings and results of this study will provide timely insight into this important issue to scholars and policy makers.