Sovereign Debt Ratchets and Welfare Destruction

Peter DeMarzo, Zhiguo He and Fabrice Tourre

Journal of Political Economy, 2023, vol. 131, issue 10, 2825 - 2892

Abstract: We study an impatient, risk-neutral government that cannot commit to a particular debt path, financed by competitive lenders. In equilibrium, debt adjusts slowly toward a debt-to-income target, exacerbating booms and busts. Strikingly, gains from trade dissipate when trading is continuous, leaving the government no better off than in financial autarky, owing to a sovereign “debt ratchet effect.” Moreover, citizens who are more patient than their government are strictly harmed. We characterize equilibrium debt dynamics, ergodics, and comparative statics when income follows a geometric Brownian motion and analyze devices that allow the sovereign to recapture gains from trade.

Date: 2023
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