Efficient Frameworks for Sovereign Borrowing

33 Pages Posted: 1 Apr 2008

See all articles by Gregor Irwin

Gregor Irwin

Bank of England

Gregory Thwaites

Bank of England - Monetary Analysis

Date Written: March 2008

Abstract

This paper presents a theoretical model of strategic default to assess how national and international policymakers should seek to influence the cost of default and the distribution of bargaining power in the event of a default. We find that, in the absence of restrictions on the parameter space, deadweight costs of default should be driven to zero. Moreover, if the debtor is risk-averse, there is an optimal division of bargaining power between the debtor and its creditors. Even with restrictions on the parameter space, marginally lower deadweight costs, possibly in some combination with greater creditor bargaining power, can always raise social welfare ex ante. However, once debt has been contracted, the debtor's trade-off between creditor bargaining power and deadweight costs changes fundamentally. In equilibrium, the deadweight costs of default may therefore tend to be too high, and the allocation of bargaining power inefficiently skewed towards the debtor. The challenge for policymakers is to find credible, time-consistent combinations of policies that can both reduce deadweight costs and shift bargaining power towards creditors.

Keywords: sovereign debt, default, restructuring

JEL Classification: F34, G15

Suggested Citation

Irwin, Gregor and Thwaites, Gregory, Efficient Frameworks for Sovereign Borrowing (March 2008). Bank of England Working Paper No. 343, Available at SSRN: https://ssrn.com/abstract=1114080 or http://dx.doi.org/10.2139/ssrn.1114080

Gregor Irwin (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Gregory Thwaites

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

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