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Federal Reserve Bank of Philadelphia
Working Papers
History Remembered: Optimal Sovereign Default on Domestic and External Debt
Pablo D'Erasmo
Enrique G. Mendoza

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.

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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.
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Keywords: public debt; sovereign default; debt crisis; European crisis
DOI: https://doi.org/10.21799/frbp.wp.2019.31
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