Working Paper（21-010E）Debt overhang and lack of lender’s commitment

The debt overhang of sovereigns or firms is modeled in the recent literature as a constrained efficient outcome of dynamic debt contracts under the lack of the bor-rower’s commitment, where debt relief is not Pareto improving. The early literature observes another type of debt overhang where the borrower is discouraged from ex-pending effort, anticipating that the lender will take all output ex post. We show that this inefficiency is due to the lack of the lender’s commitment and that debt relief is Pareto improving. Nevertheless, debt overhang may persist, as frictional bargaining over debt relief can take a long time.

Key words: Backloading, debt Laffer curve, two-sided lack of commitment.

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