History Remembered: Optimal Sovereign Default on Domestic and External Debt

59 Pages Posted: 24 Sep 2018

See all articles by Pablo D'Erasmo

Pablo D'Erasmo

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Multiple version iconThere are 3 versions of this paper

Date Written: September 2018

Abstract

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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Suggested Citation

D'Erasmo, Pablo and Mendoza, Enrique G., History Remembered: Optimal Sovereign Default on Domestic and External Debt (September 2018). NBER Working Paper No. w25073. Available at SSRN: https://ssrn.com/abstract=3254048

Pablo D'Erasmo (Contact Author)

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

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Enrique G. Mendoza

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

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