A Theory of Public Debt Overhang

In this paper we analyze the effects of unsustainable public debt on technology choice and economic growth. Unsustainable public debt undermines the credibility of government policy because the government will do whatever necessary to postpone fiscal consolidation, as an incumbent government inevitably falls from power upon implementing fiscal consolidation. We show that the lack of commitment makes firms’ choice of technology inefficient. Fiscal consolidation can restore credibility and high growth in the baseline model, while with a different policy setting in the modified model fiscal consolidation may not be able to restore redibility and growth if it is implemented too late.