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 when the government is both myopic and self-interested. Surprisingly, government myopia can increase a country’s access to external borrowing and extend the government’s effective horizon, giving 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 abroad. However, in a country that saves little, the government may engage in repressive tax policies to channel domestic savings into government bonds. This increases future governments’ costs of default, and in turn enhances current debt capacity and spending, but can lead to a “growth trap” where steady-state household consumption is lower than without government’s access to external borrowing.