Sovereign Debt Ratchets and Welfare Destruction

An impatient and risk-neutral borrower can sell bonds to a more patient group of competitive lenders. The key problem: the borrower cannot commit to either a particular financing strategy, or a default strategy. In equilibrium, lending occurs, but gains from trade end up entirely dissipated, as lenders compete with each other and the borrower competes with himself. We uncover this striking result by taking a standard sovereign default model and modifying it by (i) using a government with linear preferences, and (ii) shrinking to zero the time period during which such government can commit. We show that the financing policy of the government can be computed as the ratio of (i) the wedge between the government discount rate and the return required by investors, and (ii) the semi-elasticity of the bond price function w.r.t. the debt face value. We overturn an old result of Bulow and Rogoff (1988), which argues that a borrower should never buy back his own bonds. We analyze commitment devices that allow the borrower to recapture some of the gains from trade – sovereign debt ceilings and constant issuance policies.