Testing Times: Reputation for Debt Discipline

How do countries build a reputation for debt discipline? I develop a continuoustime model in which an impatient government, whose income follows a jumpdiffusion process, finances consumption by issuing long-term debt to patient investors. The opportunistic government cannot commit to future debt policies and builds reputation by mimicking a commitment type that maintains a stable debtto-income ratio. I characterize a Markov perfect equilibrium in closed form. Reputation building is necessarily slow and confined to "testing times," episodes of large negative shocks during which debt reduction becomes a credible signal of commitment. Reputation building is path-dependent and risky: a single large shock builds reputation faster than a sequence of smaller ones, yet it also raises the risk of reputation loss. Because reputation is built through disciplined debt management rather than timely repayment, its loss need not trigger immediate default; instead, it shifts bondholders' expectations about future debt policy, generating divergent paths for countries that maintain reputation and those that lose it. With positive reputation, debt prices decouple from current debt ratios and are driven primarily by the history of past "tests." Without reputation, bondholders anticipate continuous issuance and dilution, so debt prices become sensitive to-and decreasing in-current debt ratios.