Front Matter Page
Research Department
Contents
Summary
I. Introduction
II. The Economy
III. Partial Commitment
IV. No Commitment
V. Characterization of Sustainable Outcomes
VI. Uncertainty
VII. Anonymous Games
VI. Conclusion
References
Figure 1. Sustainable Utilities vs. The Discount Factor
Figure 2. Sustainable Utilities vs. The Variance of Government Consumption
Summary
This paper presents a model in which both private borrowers and the government can default on their debt. It is easy to imagine conditions under which the government can, at least partially, default on its debt and, at the same time, have difficulty collecting debts owed to it by private citizens, such as students or farmers.
The analysis considers an extreme situation in which the government can enforce no private debt claims. Nevertheless, the analysis indicates that the government has good reasons not to default on its debt. If it defaults, private agents may never again lend to it. Moreover, since in the model it cannot enforce debt payments by private agents, the government cannot safely lend to the private sector. Thus, a situation arises in which, if the government ever defaults, it must thereafter continuously balance its budget. If forced to balance its budget annually, the government cannot smooth taxes, and this leads to a low level of welfare.
Thus, the losses attendant on banning the government from future borrowing are large. Under plausible assumptions, the analysis shows that these losses can be large enough to deter the government from ever defaulting.