Optimal Debt Relief Under Threat of Trade Punishments

Abstract

The theory of optimal debt relief hinges critically on the assumption that the output of a defaulting debtor country can be partially confiscated by the creditors. This assumption is at odds with the crucial feature of international credit relationships. The present paper focuses on an alternative enforcement method, namely the impediment of international trade. It is shown that a similar result can be derived. Additionally, it can be rational to grant further credit to countries with very little initial endowment, even though it is clear to the creditors that they will make a debt relief afterwards.

JEL Classification: F34