Sovereign Debt Ratchets and Welfare Destruction

Peter DeMarzo, Zhiguo He () and Fabrice Tourre

No 28599, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: An impatient and risk-neutral government can sell bonds at any time to a more patient group of competitive lenders. The key problem: the government cannot commit to either a particular financing strategy, or a default strategy. Despite risk-neutrality, in equilibrium debt adjusts slowly towards a target debt-to-income level, exacerbating booms and busts. Most strikingly, for any debt maturity structure, the gains from trade are entirely dissipated when trading opportunities are continuous, as lenders compete with each other and the government competes with itself. Moreover, citizens who are more patient than their government are strictly harmed by the unrestricted borrowing. We fully characterize debt dynamics, ergodics, and comparative statics when income follows a geometric Brownian motion, and analyze several commitment devices that allow the sovereign to recapture some gains from trade: self-imposed restrictions on debt issuances and levels, as well as “market-imposed” discipline.

JEL-codes: C73 F32 F38 F43 F51 G12 (search for similar items in EconPapers)
Date: 2021-03
New Economics Papers: this item is included in nep-opm
Note: AP CF DEV EFG IFM ITI ME POL
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Citations: View citations in EconPapers (3)

Published as Peter DeMarzo & Zhiguo He & Fabrice Tourre, 2023. "Sovereign Debt Ratchets and Welfare Destruction," Journal of Political Economy, vol 131(10), pages 2825-2892.

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