Working Paper: NBER ID: w25073
Authors: Pablo Derasmo; Enrique G. Mendoza
Abstract: Infrequent but turbulent overt sovereign defaults on domestic creditors are a “forgotten 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 v. 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: Sovereign default; Public debt; Heterogeneous agents; Risk-sharing; Economic policy
JEL Codes: E44; E63; F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government's choice to default on domestic debt (H63) | redistribution of resources across agents (D30) |
| government's inability to commit to repayment (H63) | reduction in sustainable debt levels (F34) |
| increasing debt levels (H63) | likelihood of default (G33) |
| distribution of bond holdings (G12) | utility cost of default (L97) |
| defaults (Y60) | wipe out the debt holdings of all agents (F65) |
| social welfare gain from default (D69) | aggregation of individual utility gains from default across agents outweighs the costs associated with default (D81) |