On Credibility and Distribution

In representative agent models, optimal tax-smoothing debt strategies are usually time inconsistent. Moreover, even the threat of being permanently excluded from debt markets may be insufficient to deter a benevolent government from defaulting. However, when only a subset of agents participate in debt markets, debt payments represent a transfer from tax payers as a whole to debt market participants. If the debt market participants possess sufficient political influence they will seek to block debt default, thus rendering debt sustainable in equilibrium. The paper develops new methods for characterising sustainable fiscal policies in such environments.