Political Intervention in Debt Contracts

Abstract

This paper develops a dynamic general equilibrium model of an agricultural economy in which poor farmers borrow from rich farmers. Because output is stochastic (we allow for idiosyncratic and aggregate shocks) there may be default ex-post. We compare equilibria with and without political intervention. Intervention takes the form of a moratorium and is decided by majority rule. When bad economic shocks are highly likely, state contingent debt moratoria always improve ex-post efficiency and may also improve ex-ante efficiency. Moreover the threat of moratoria enhances efficiency. When adverse macro shocks are unlikely, state contingent moratoria always improve ex-ante welfare by completing incomplete debt contracts.