Federal Reserve Bank of Philadelphia
History Remembered: Optimal Sovereign Default on Domestic and External Debt
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.
Cite this item
Pablo D'Erasmo & Enrique G. Mendoza, History Remembered: Optimal Sovereign Default on Domestic and External Debt, Federal Reserve Bank of Philadelphia, Working Papers 19-31, 22 Jul 2019.
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
Keywords: public debt; sovereign default; debt crisis; European crisis
This item with handle RePEc:fip:fedpwp:19-31
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