Under what circumstances can market forces prevent unsustainable borrowing? Market discipline implies that lenders penalize excessive borrowing, first, by requiring a higher interest rate spread and, ultimately, by excluding the borrower from the market.
For market discipline to work effectively, capital markets must be open; information on the borrower’s outstanding liabilities must be readily available; there must be no bailout anticipated; and the borrower must respond to market signals provided by interest rate spreads.
This paper explores these conditions, focusing on four examples. The first is fiscal policy in a currency union, such as the planned Economic and Monetary Union in the European Community, where there is concern that, unless binding fiscal rules are imposed, member countries may incur excessive deficits. Another instance is sovereign debt: can private lenders provide sovereign borrowers with adequate incentives to pursue policies consistent with solvency? Yet another instance pertains to the regulation of financial institutions: can markets induce intermediaries to make prudent lending decisions, or is some direct supervision necessary? Finally, there is the soft budget constraint facing state enterprises in socialist economies: how can these enterprises be induced to behave in a manner consistent with their long-run solvency and to continue to operate only if they are solvent?
The latter part of the paper reviews some empirical evidence on market discipline. First, the experience of federal unions ranges from tight central control of borrowing by lower levels of government to virtually complete reliance on market forces, with no apparent corresponding pattern in the effectiveness of fiscal discipline. While evidence regarding sovereign debt suggests some weakness in market discipline, it also indicates that lenders do discriminate among borrowers on the basis of information regarding their solvency. Models of optimal fiscal policy imply that a government uses its borrowing to smooth tax rates despite variations in economic conditions and expenditure requirements; empirical tests of these models support this implication but also suggest that borrowing is systematically influenced by the political structure. The evidence therefore suggests that although market discipline is an important force, it is not always strong enough to prevent unsustainable borrowing.
In the diverse cases examined, the conditions required for market discipline to be effective are essentially the same, as are the conditions likely to undermine market discipline. The “no-bailout” condition, in particular, is often the Achilles’ heel of market discipline, especially because of the difficulty of making such a condition credible. The solutions are also similar: market discipline may have to be reinforced by some kind of direct controls or rules, but it is also important to implement measures to strengthen market discipline itself.