A Rule-based Time-consistent Path of Debt Use for Subnational Governments – Debt as a Countercyclical Fiscal Policy Tool

This paper formulates a model of countercyclical use of long-term full faith and credit debt by subnational governments to finance infrastructure. The model incorporates long-term debt into budgetary policy, considering debt capacity, purposes and security of debt, and equity. The proposition is to retire debt in boom years to preserve debt capacity and reduce borrowing costs, and then incur more debt at a lower interest rate in bust years to help maintain service provision and pave the way for recovery. I conduct time series and panel data tests to answer: do subnational governments use debt countercyclically? What determines the cyclical patterns in subnational use of debt? Will countercyclical debt issue and retirement be applicable? Results using US states data show that overall, US states do not tend to use debt against the economic cycle; however, I obtain evidence that at least some states 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 provide timely insight into this important issue to scholars and policy makers