On the Limitations of Government Borrowing: A Framework for Empirical Testing

James D. Hamilton, Marjorie A. Flavin

NBER Working Paper No. 1632
Issued in June 1985
NBER Program(s):   EFG

This paper seeks to distinguish empirically between two views on the limitations of government borrowing. According to one view, nothing precludes the government from running a permanent budget deficit, paying interest due on the growing debt load simply by issuing new debt, An alternative perspective holds that creditors would be unwilling to purchase government debt unless the government made a credible commitment to balance its budget in present value terms. We show that distinguishing between these possibilities is mathematically equivalent to testing whether a continuing currency inflation might be fueled by speculation alone or is instead driven solely by economic fundamentals. Empirical tests which have been developed for this economic question lead us to conclude that postwar U.S. deficits are largely consistent with the proposition that the government budget must be balanced in present-value terms.

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Published: Hamilton, James D. and Marjorie Flavin,"On the Limitations of Governemnt Borrowing: A Framework for Empirical Testing,"American Economic Review, Vol. 76, No. 4, September 1986.

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