Working Paper: NBER ID: w28599
Authors: 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.
Keywords: No keywords provided
JEL Codes: C73; F32; F38; F43; F51; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government's inability to commit to a fiscal path (H69) | Welfare losses for government and citizens (D69) |
| Government can borrow from patient lenders but fails to capture welfare benefits (H53) | Welfare losses for citizens (D69) |
| Government's inability to commit (H11) | Government's borrowing options undermined (H74) |
| Government's borrowing options undermined (H74) | Negative welfare implications of unrestricted borrowing (F65) |
| Citizens worse off in open capital market scenario (F65) | Financial autarky preferable for citizens (H69) |
| Welfare gains from trade converge to zero as trading opportunities become continuous (D69) | No improvement in welfare outcomes for government (H53) |