History Remembered: Optimal Sovereign Default on Domestic and External Debt

88 Pages Posted: 23 Oct 2019 Last revised: 24 Oct 2019

See all articles by Pablo D'Erasmo

Pablo D'Erasmo

Federal Reserve Bank of Philadelphia - Research Department

Enrique Mendoza

University of Pennsylvania

Multiple version iconThere are 3 versions of this paper

Date Written: July, 2019

Abstract

Infrequent but turbulent overt sovereign defaults on domestic creditors are a ?for- gotten 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 defaults, 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 (July, 2019). 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 Bank of Philadelphia - Research Department ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Enrique Mendoza

University of Pennsylvania

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