Optimal Time Consistent Government Debt Maturity, Fiscal Policy, and Default

Author develops a tractable model to study the optimal debt maturity structure and fiscal policy in an environment with incomplete markets, lack of commitment, and opportunity to default by the government. The default on public debt is endogenous and the real interest rate reflects the default risk and the marginal rate of substitution between present and future consumption. I show that the Lucas and Stokey (1983) time-consistency result can be extended to environments with an opportunity of outright default. The maturity is used to resolve the time-consistency problem: The present government can incentivize future governments to stick to an ex ante optimal sequence of fiscal policies and interest rates. I show that if both risk-free interest rates and risk premiums can be manipulated, the optimal maturity structure tends to have a decaying profile: The government issues debt at all maturity dates, but the distribution of payments over time is skewed toward the short end. The model allows for numerical characterization of the optimal maturity structure of debt with arbitrarily large number of maturities. Debt maturity data across countries are consistent with model predictions.