How Can Governments Borrow so Much?

We analyze the determinants of government debt under the twin assumptions that governments have limited horizons and default only when government income falls short of debt service requirements. We derive a government’s maximum sustainable debt ratio, that is, the debt ratio chosen by a myopic government whose horizon does not extend beyond its current term in office. Maximum sustainable debt varies across countries, consistent with Reinhart, Rogoff, and Sevastano’s (2003) evidence of different countries’ differing debt (in)tolerance. Actual debt ratios are below their maximum sustainable levels, as governments seeking further terms in office fear debt-induced default that may jeopardize their prospects for reelection. The difference between actual and maximum sustainable debt ratios creates a ‘margin of safety’ that allows governments to increase debt if necessary with little corresponding increase in default risk. The probability of default climbs precipitously once the margin of safety has been exhausted.