The Limits of political compromise: debt ceilings and political competition

We study the desirability of limits on the public debt and of political competition in an economy where political parties alternate in office. Due to rent-seeking motives, incumbents have an incentive to set public expenditures above the socially optimal level. Parties cannot commit to future policies, but they can forge a political compromise where each party curbs excessive spending when in office if it expects future governments to do the same. In contrast to the received literature, we find that strict limits on government borrowing can exacerbate political-economy distortions by rendering a political compromise unsustainable. This tends to happen when political competition is limited. Conversely, a tight limit on the public debt fosters a compromise that yields the efficient outcome when political competition is vigorous, saving the economy from immiseration. Our analysis thus suggests a legislative tradeoff between restricting political competition and constraining the ability of governments to issue debt.

Escola de Economia de São Paulo