History Remembered: Optimal Sovereign Default on Domestic and External Debt

D'Erasmo, Pablo; Mendoza, Enrique G.

doi:https://doi.org/10.21799/frbp.wp.2019.31

Working Paper

History Remembered: Optimal Sovereign Default on Domestic and External Debt

Abstract: Infrequent but turbulent overt sovereign defaults on domestic creditors are a ?for- gotten history? in macroeconomics. We propose a heterogeneous-agents model in which the government chooses optimal debt and default on domestic and foreign creditors by balancing distributional incentives versus the social value of debt for self-insurance, liquidity, and risk-sharing. A rich feedback mechanism links debt issuance, the distribution of debt holdings, the default decision, and risk premia. Calibrated to Eurozone data, the model is consistent with key long-run and debt-crisis statistics. Defaults are rare (1.2 percent frequency) and preceded by surging debt and spreads. Debt sells at the risk-free price most of the time, but the government?s lack of commitment reduces sustainable debt sharply.

Keywords: public debt; sovereign defaults; debt crisis; European crisis;

JEL Classification: E44; E6; F34; H63;

https://doi.org/https://doi.org/10.21799/frbp.wp.2019.31