Sovereign Debt and Structural Reforms

50 Pages Posted: 12 May 2015

See all articles by Andreas Müller

Andreas Müller

University of Oslo, Department of Economics

Kjetil Storesletten

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Fabrizio Zilibotti

Yale University; Centre for Economic Policy Research (CEPR)

Date Written: May 2015

Abstract

Motivated the European debt crisis, we construct a tractable theory of sovereign debt and structural reforms under limited commitment. The government of a sovereign country which has fallen into a recession of an uncertain duration issues one-period debt and can renege on its obligations by suffering a stochastic default cost. When faced with a credible default threat, creditors can make a take-it-or-leave-it debt haircut offer to the sovereign. The risk of renegotiation is reflected in the price at which debt is sold. The sovereign government can also do structural policy reforms that speed up recovery from the recession. We characterize the competitive equilibrium and compare it with the constrained efficient allocation. The equilibrium features increasing debt, falling consumption, and a non-monotone reform effort during the recession. In contrast, the constrained optimum yields step-wise increasing consumption and step-wise decreasing reform effort. Markets for state-contingent debt alone do not restore efficiency. The constrained optimum can be implemented by a flexible assistance program enforced by an international institution that monitors the reform effort. The terms of the program are improved every time the country poses a credible threat to leave the program unilaterally without repaying the outstanding loans.

Keywords: austerity programs, debt overhang, default, European debt crisis, fiscal policy, Great Recession, Greece, International Monetary Fund, limited commitment, moral hazard, renegotiation, risk premia, sovereign debt, structural reforms

JEL Classification: E62, F33, F34, F53, H12, H63

Suggested Citation

Müller, Andreas and Storesletten, Kjetil and Zilibotti, Fabrizio, Sovereign Debt and Structural Reforms (May 2015). CEPR Discussion Paper No. DP10588, Available at SSRN: https://ssrn.com/abstract=2605023

Andreas Müller (Contact Author)

University of Oslo, Department of Economics ( email )

P.O. Box 1095 Blindern
N-0317 Oslo
Norway

HOME PAGE: http://www.sv.uio.no/econ/english/people/aca/andrmu/index.html

Kjetil Storesletten

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

Fabrizio Zilibotti

Yale University ( email )

New Haven, CT 06520
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
0
Abstract Views
1,042
PlumX Metrics