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An efficient capital market can impose a debt brake by charging higher interest rates on jurisdictions that incur deficits and accumulate debt, compared to jurisdictions that balance their budgets and limit debt. At the national level this form of capital market discipline has become more important since the financial crisis. State and local governments in the U.S. are more sensitive to the constraints imposed by credit markets compared to the federal government. Credit ratings on debt issued by state and local governments vary considerable; and the interest rates charged for debt issued by state and local governments varies considerably as well.
The real cost of government bailouts is the impact these bailout policies had on incentives in both the private and public sectors. The perception grows that the federal government is not able to constrain debt, exposing the country to increasing risk of default. Credit markets punish this profligacy by charging higher interest rates reflecting the risk of default in the U.S. compared to Eurozone countries (Botev et al 2016; Fournier and Fall 2015; NBER 2011; Fall et al. 2015; Fall and Fournier 2015; Lo and Rogoff 2015; Nickel and Tudyka 2014; OECD 2016; Turner and Spinelli 2013). .

During the financial crisis, credit rating agencies downgraded U.S. debt. The divergence in interest rates on U.S. debt compared to debt issued by some Eurozone nations is a measure of the risk premium now demanded by credit markets. As a reserve currency country the U.S. has a significant advantage in issuing new debt compared to other countries. The size of the U.S. capital market and economy allows the federal government to issue debt with greater credibility in servicing that debt. Small countries, such as Switzerland, are more constrained by credit markets in issuing debt (Merrifield and Poulson 2016b, 2017).

Capital markets in the U.S. are considered to be the most efficient in the world in assessing the creditworthiness of borrowers. However, massive bailout of borrowers in both the private and public sector since the financial crisis has undermined this capital market efficiency. When borrowers can count on government bailouts, credit markets have little incentive to practice due diligence in assessing the creditworthiness of potential borrowers. ‘No-bailout’ rules are now required in order to restore capital market efficiency, for the proposed fiscal rules to be effective. The rules must also restore the role for insolvency and bankruptcy laws for capital markets to impose fiscal discipline.

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Market-Based Constraints: Bondholders and Creditors as Debt Brakes

One thought on “Market-Based Constraints: Bondholders and Creditors as Debt Brakes

  • May 28, 2022 at 5:32 PM

    Heya this is kind of of off topic but I was wondering if blogs use WYSIWYG editors or if you have to manually code with HTML. I’m starting a blog soon but have no coding know-how so I wanted to get advice from someone with experience. Any help would be greatly appreciated!


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