Working Paper: CEPR ID: DP10588
Authors: Andreas Müller; Kjetil Storesletten; Fabrizio Zilibotti
Abstract: Motivated the European debt crisis, we construct a tractable theory of sovereign debt and structural reforms under limited commitment. The government of a sovereign country which has fallen into a recession of an uncertain duration issues one-period debt and can renege on its obligations by suffering a stochastic default cost. When faced with a credible default threat, creditors can make a take-it-or-leave-it debt haircut offer to the sovereign. The risk of renegotiation is reflected in the price at which debt is sold. The sovereign government can also do structural policy reforms that speed up recovery from the recession. We characterize the competitive equilibrium and compare it with the constrained efficient allocation. The equilibrium features increasing debt, falling consumption, and a non-monotone reform effort during the recession. In contrast, the constrained optimum yields step-wise increasing consumption and step-wise decreasing reform effort. Markets for state-contingent debt alone do not restore efficiency. The constrained optimum can be implemented by a flexible assistance program enforced by an international institution that monitors the reform effort. The terms of the program are improved every time the country poses a credible threat to leave the program unilaterally without repaying the outstanding loans.
Keywords: Austerity Programs; Debt Overhang; Default; European Debt Crisis; Fiscal Policy; Great Recession; Greece; International Monetary Fund; Limited Commitment; Moral Hazard; Renegotiation; Risk Premia; Sovereign Debt; Structural Reforms
JEL Codes: E62; F33; F34; F53; H12; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increasing debt (H63) | falling consumption (E21) |
| increasing debt (H63) | non-monotonic reform effort (E69) |
| stochastic nature of default costs (G33) | creditors' willingness to renegotiate debt terms (F34) |
| accumulating debt (H74) | higher risk premium (G19) |
| higher risk premium (G19) | decline in consumption (D12) |
| flexible assistance program (I38) | improve terms of program (C88) |
| credible threat to exit unilaterally (D74) | improve terms of assistance program (I38) |
| appeasing credible default threat (F34) | avert outright default (G33) |
| implementing assistance program (I38) | yield significant welfare gains (D69) |