Department of Economics College of Business & Economics University of Delaware

Is a balanced-budget rule compatible with a government honoring its debt obligations? According to the conventional explanation, governments honor their debt obligations to maintain a good reputation for future borrowing. The ability to borrow is desirable because it allows for greater tax smoothing. However, a balanced-budget rule limits the ability to smooth taxes, rendering a large class of competitive equilibria not compatible with a government honoring its debt obligations. The reputation model predicts default as the equilibrium outcome under a balanced-budget restriction. Insofar as this prediction is falsified by empirical observation, mechanisms other than reputation must be at work. JEL Classification: E61, H21, H63 ∗This paper is a substantially revised chapter from my Ph.D. dissertation in economics at University of Chicago. I would like to thank Larry Christiano, Michael Chwe, Lars Hansen, Tom Sargent, an anonymous referee, and seminar participants at the University of Delaware, Williams College, SUNY-Albany, and Congressional Budget Office for helpful comments. All remaining errors are mine. E-mail: [email protected].