Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default
72 Pages Posted: 10 Aug 2016
Date Written: 2016-08-09
Europe’s debt crisis resembles historical episodes of outright default on domestic public debt about which little research exists. This paper proposes a theory of domestic sovereign default based on distributional incentives affecting the welfare of risk-averse debt and non-debtholders. A utilitarian government cannot sustain debt if default is costless. If default is costly, debt with default risk is sustainable, and debt falls as the concentration of debt ownership rises. A government favoring bondholders can also sustain debt, with debt rising as ownership becomes more concentrated. These results are robust to adding foreign investors, redistributive taxes, or a second asset.
Keywords: Public debt, Sovereign default, European debt crisis
JEL Classification: E44, E6, F34, H63
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