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Teulings, C. N.

Are Bubbles Bad? Is a higher debt target for the Euro-zone desirable?

WP Number: 1609

Abstract: Bubbles are usually viewed as a threat to financial stability. This paper takes a more nuanced view. The world economy is going through an episode of Secular Stagnation, where the equilibrium rate of return on capital r is below the growth rate of the economy g. As is well-known, rational bubbles are sustainable when r ≤ g in a steady-state equilibrium. Bubbles can then implement a dynamically efficient equilibrium. We show that from a structural point of view, bubbles, Pay-As-You-Go pensions, and sovereign debt are perfect substitutes. However, when dealing with unexpected short-run fluctuations in investment, sovereign debt is far more efficient than bubbles in shifting consumption over time and in risk-sharing between generations. An increase in sovereign debt is, therefore, an efficient response to Secular Stagnation. Instead, the current Stability and Growth Pact for the eurozone embarks on an opposite course.

Keywords: bubbles, dynamic efficiency, fiscal policy, Secular Stagnation

JEL Codes: E44 E62

Author links:

PDF: wp1609.pdf

Open Access Link: 10.17863/CAM.1070

Published Version of Paper: Are bubbles bad? Is a higher debt target for the Eurozone desirable?, Teulings, C., CESifo Economic Studies (2016)