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

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  • Coen N. Teulings

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 (PAYG) 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 Euro-zone embarks on an opposite course.

Suggested Citation

  • Coen N. Teulings, 2016. "Are Bubbles Bad? Is a higher debt target for the Euro-zone desirable?," Cambridge Working Papers in Economics 1643, Faculty of Economics, University of Cambridge.
    • Handle: RePEc:cam:camdae:1643
    Note: cnt23
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    Cited by:

    1. Gómez-Puig, Marta & Sosvilla-Rivero, Simón, 2017. "Heterogeneity in the debt-growth nexus: Evidence from EMU countries," International Review of Economics & Finance, Elsevier, vol. 51(C), pages 470-486.

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    More about this item

    Keywords

    bubbles; dynamic efficiency; fiscal policy; Secular Stagnation;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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