Present-biased government and sovereign debt dynamics

Abstract

This paper studies the sovereign debt dynamics when the government exhibits present-biased preferences and can freely adjust sovereign debt. First, present bias plays a dual role. If the country is moderately indebted, the desire for instantaneous gratification drives the government to issue debt. However, with excessive indebtedness, the top concern is to procrastinate costly default, and present bias serves as an implicit commitment device that induces the government to repurchase existing debt. Second, the severe present-biased government suffers from debt intolerance: it has small debt capacity and pays high sovereign credit spreads, despite potentially maintaining a low target debt level. Finally, we find that long-term debt and budgetary restriction can mitigate the negative impact of present bias by disciplining the government’s over-borrowing incentives.