Sovereign Debt and Economic Growth when Government is Myopic and Self-interested

Abstract

We examine how a sovereign’s ability to borrow abroad affects the country’s growth
and steady state consumption, assuming that the government is both myopic and
self-interested. Surprisingly, government myopia can increase a country’s access
to external borrowing. In turn, access to borrowing can extend the government’s
effective horizon as the government’s ability to borrow hinges on it convincing creditors
they will be repaid, which gives it a stake in incentivizing private production
and savings despite its self-interest. In a high-saving country, the lengthening of the
government’s effective horizon can incentivize it to tax less, resulting in a “growth
boost", with higher steady-state household consumption than if it could not borrow.
However, in a country that saves little, the government may engage in more repressive
policies to enhance its debt capacity and spending. This could lead to a “growth
trap” where household steady-state consumption is lower than if the government
had no access to external borrowing. We discuss the effectiveness of alternative
debt policies, including declaring the sovereign’s debt “odious”, debt relief, and
debt ceilings.

Keywords: Sovereign debt, government myopia, financial repression, allocation puzzle, debt ceiling

JEL Classification: F3, G28, H2, H3, H6