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Sovereign Debt Ratchets and Welfare Destruction

Author

Listed:
  • Peter M. DeMarzo
  • Zhiguo He
  • Fabrice Tourre

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.

Suggested Citation

  • Peter M. DeMarzo & Zhiguo He & Fabrice Tourre, 2021. "Sovereign Debt Ratchets and Welfare Destruction," NBER Working Papers 28599, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:28599
    Note: AP CF DEV EFG IFM ITI ME POL
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    Cited by:

    1. Sergio Rebelo & Neng Wang & Jinqiang Yang, 2022. "Rare Disasters, Financial Development, and Sovereign Debt," Journal of Finance, American Finance Association, vol. 77(5), pages 2719-2764, October.
    2. Peter M. Demarzo & Zhiguo He, 2021. "Leverage Dynamics without Commitment," Journal of Finance, American Finance Association, vol. 76(3), pages 1195-1250, June.
    3. Bloise, Gaetano & Vailakis, Yiannis, 2024. "Sovereign debt crises and low interest rates," Journal of International Economics, Elsevier, vol. 150(C).
    4. Li, Yuan & Yang, Jinqiang & Zhao, Siqi, 2022. "Present-biased government and sovereign debt dynamics," Journal of Mathematical Economics, Elsevier, vol. 98(C).

    More about this item

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
    • F51 - International Economics - - International Relations, National Security, and International Political Economy - - - International Conflicts; Negotiations; Sanctions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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