“Debt-Maturity without Commitment,” CEPR, 2008

CEPR Discussion Paper 7093, December 2008. PDF.

We analyze how sovereign risk paired with social costs of default shapes the maturity structure of public debt. A government without commitment power balances benefits of default, due to tax savings, and costs, due to output losses. Debt issuance affects subsequent default and rollover decisions and thus, current debt prices. This induces welfare costs beyond the consumption smoothing benefits from the marginal unit of debt. The equilibrium choice of short- versus long-term debt issuance minimizes these welfare costs. Consistent with empirical evidence, closed-form solutions of the model predict an interior maturity structure with positive gross positions and a shortening of the maturity structure during times of crisis and low output. In simulations, the model replicates additional features of the data.