History Remembered: Optimal Sovereign Default on Domestic and External Debt

88 Pages Posted: 23 Oct 2019

See all articles by Pablo D'Erasmo

Pablo D'Erasmo

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Enrique Mendoza

University of Pennsylvania

Multiple version iconThere are 3 versions of this paper

Date Written: 2019-07-22

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 versus 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.

Keywords: public debt, sovereign default, debt crisis, European crisis

JEL Classification: E44, E6, F34, H63

Suggested Citation

D'Erasmo, Pablo and Mendoza, Enrique, History Remembered: Optimal Sovereign Default on Domestic and External Debt (2019-07-22). FRB of Philadelphia Working Paper No. 19-31. Available at SSRN: https://ssrn.com/abstract=3474355 or http://dx.doi.org/https://doi.org/10.21799/frbp.wp.2019.31

Pablo D'Erasmo (Contact Author)

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

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Enrique Mendoza

University of Pennsylvania

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