Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default
The European debt crisis shares features of the historical episodes of outright default on domestic public debt identified by Reinhart and Rogoff (2008) as a forgotten research subject. This paper proposes a theory of domestic sovereign default in which a government chooses debt and default optimally, responding to distributional incentives affecting the welfare of risk-averse agents who are heterogeneous in wealth. Equilibria with debt do not exist if the government is utilitarian and default is costless. Adding an exogenous default cost, the model supports equilibria with debt exposed to default risk in which debt falls as wealth inequality rises. A quantitative experiment calibrated to Europe shows that, in the observed range of inequality in bond holdings, the model accounts for 1/3rd of the median debt ratio at a default probability of 0.9%, and the debt is sharply lower than in the absence of default risk. Equilibria with debt also exist if, instead of default costs, a political bias leads the government to weigh its creditors' welfare by more than their wealth share. Quantitatively, combining default costs and political bias yields debt ratios similar to Europe's at low default probabilities.
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This paper was revised on March 19, 2014
Document Object Identifier (DOI): 10.3386/w19477
Forthcoming: Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default, Pablo D'Erasmo, Enrique G. Mendoza. in Sovereign Debt and Financial Crisis, Kalemli-Ozcan, Reinhart, and Rogoff. 2014
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