Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default
International historical records on public debt show infrequent episodes of outright default on domestic debt. Reinhart and Rogoff (2008) document these events and argue that they constitute a “forgotten history” in Macroeconomics. This paper develops a theory of domestic sovereign default in which distributional incentives, interacting with default costs, make default part of the optimal policy of a utilitarian social planner. The model supports equilibria with debt subject to default risk in which rising wealth inequality reduces the optimal debt and increases default probabilities and spreads. A quantitative experiment calibrated to European data shows that, in the observed range of inequality in the distribution of bond holdings, the model accounts for 1/3rd of the average debt and spreads of about 400 basis points. Default risk reduces sharply the sustainable debt, except when the weights in the government’s payoff function value the utility of bond holders more than their share of the wealth distribution. If the former is sufficiently larger than the latter, the model supports debt ratios similar to European averages exposed to low default probabilities.
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