Concerns about constructing and maintaining good reputations are known to reduce borrowers’ excessive risk-taking. However, I find that the self-discipline induced by these concerns is fragile, and can break down without obvious changes in economic fundamentals. Furthermore, in the aggregate, breakdowns are clustered among borrowers with intermediate and good reputations, which can exacerbate an economy’s weakness and contribute to a broad economic crisis. These results come from an aggregate dynamic global game analysis of reputation formation in credit markets. The selection of a unique equilibrium is accomplished by assuming that borrowers have incomplete information about economic fundamentals.

A traditional explanation for why sovereign governments repay debts is that they want to keep good reputations so they can easily borrow more. Bulow and Rogoff show that this argument is invalid under two conditions: (i) there is a single debt relationship, and (ii) regardless of their past actions, governments can earn the (possibly state-contingent) market rate of return by saving abroad. Bulow and Rogoff conjecture that, even under condition (ii), in more general reputation models with multiple relationships and spillover across them, reputation may support debt. This paper shows what is needed for this conjecture to be true.

A standard explanation for why sovereign governments repay their debts is that they must maintain a good reputation to easily borrow more. We show that the ability of reputation to support debt depends critically on the assumptions made about institutions. At one extreme, we assume that bankers can default on payments they owe to governments. At the other, we assume that bankers are committed to honoring contracts made with governments. We show that if bankers can default, then a government gets enduring benefits from maintaining a good relationship with bankers and its reputation can support a large amount of borrowing. If, however, bankers must honor their contracts, then a government gets only transient benefits from maintaining a good relationship and its reputation can support zero borrowing.

This paper presents a continuous-time model of sovereign debt. In it, a relatively impatient sovereign government’s hidden type switches back and forth between a commitment type, which cannot default, and an optimizing type, which can default on the country’s debt at any time, and assume outside lenders have particular beliefs regarding how a commitment type should borrow for any given level of debt and bond price. We show that if these beliefs satisfy reasonable assumptions, in any Markov equilibrium, the optimizing type mimics the commitment type when borrowing, revealing its type only by defaulting on its debt at random times. Further, in such Markov equilibria (the solution to a simple pair of ordinary differential equations), there are positive gross issuances at all dates, constant net imports as long as there is a positive equilibrium probability that the government is the optimizing type, and net debt repayment only by the commitment type. For countries that have recently defaulted, the interest rate the country pays on its debt is a decreasing function of the amount of time since its last default, and its total debt is an increasing function of the amount of time since its last default. For countries that have not recently defaulted, interest rates are constant.

In all markets, firms go through a process of creative destruction: entry, random growth and exit. In many of these markets there are also regulations that restrict entry, possibly distorting this process. We study the public interest rationale for entry taxes in a general equilibrium model with free entry and exit of firms in which firm dynamics are driven by reputation concerns. In our model firms can produce high-quality output by making a costly but efficient initial unobservable investment. If buyers never learn about this investment, an extreme “lemons problem” develops, no firm invests, and the market shuts down. Learning introduces reputation incentives such that a fraction of entrants do invest. We show that, if the market operates with spot prices, entry taxes always enhance the role of reputation to induce investment, improving welfare despite the impact of these taxes on equilibrium prices and total production.