Working Paper: NBER ID: w4007
Authors: Ishac Diwan; Dani Rodrik
Abstract: We argue that the disincentive effect of a debt overhang is generally small and consequently that debt reduction does not lead to important efficiency gains on this account. Instead, we develop a framework that highlights the inefficiency created by the liquidity constraint faced by over-indebted countries. Often, adjustment/investment opportunities that are profitable at the world interest rate cannot be undertaken for lack of sufficient funds. New creditors are deterred from investing as they expect to be 'taxed" by the old creditors who stand to gain disproportionately. This leads to an inefficient situation when a class of new creditors have a comparative advantage relative to the old creditors. We focus on the time inconsistency introduced by the shortage of liquidity. New (unconditional) loans will be consumed rather than invested. In this context conditional lending can release the liquidity constraint in a time consistent way and lead to efficiency gains that can be shared between the debtor, the old creditors, and the new creditors. The role of debt reduction then is to create the "headroom" needed for these new and more efficient creditors to step in
Keywords: debt overhang; investment; conditional lending
JEL Codes: F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| debt overhang (H63) | inefficiencies in investment (E22) |
| debt overhang (H63) | liquidity constraints (E41) |
| liquidity constraints (E41) | inability to attract new creditors (G33) |
| liquidity constraints (E41) | prevent profitable investments (G11) |
| debt overhang (H63) | prevent new creditors from entering market (G18) |
| debt reduction (H63) | create headroom for new creditors (G33) |
| conditional lending (G21) | alleviate liquidity constraints (E51) |
| debt overhang (H63) | affect investment opportunities (G11) |