NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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History Remembered: Optimal Sovereign Default on Domestic and External Debt

Pablo D'Erasmo, Enrique G. Mendoza

NBER Working Paper No. 25073
Issued in September 2018
NBER Program(s):Economic Fluctuations and Growth, International Finance and Macroeconomics

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.

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Document Object Identifier (DOI): 10.3386/w25073

Published: Pablo D’Erasmo & Enrique G. Mendoza, 2020. "History Remembered: Optimal Sovereign Default on Domestic and External Debt," Journal of Monetary Economics, .

 
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