Creator: Benjamin, David and Wright, Mark L. J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 753 Abstract:
Negotiations to restructure sovereign debt are time consuming, taking almost a decade on average to resolve. In this paper, we analyze a class of widely used complete information models of delays in sovereign debt restructuring and show that, despite superficial similarities, there are major differences across models in the driving force for equilibrium delay, the circumstances in which delay occurs, and the efficiency of the debt restructuring process. We focus on three key assumptions. First, if delay has a permanent effect on economic activity in the defaulting country, equilibrium delay often occurs; this delay can sometimes be socially efficient. Second, prohibiting debt issuance as part of a settlement makes delay less likely to occur in equilibrium. Third, when debt issuance is not fully state contingent, delay can arise because of the risk that the sovereign will default on any debt issued as part of the settlement.
Keyword: Sovereign debt, Delay, Sovereign default, and Bargaining Subject (JEL): F34 - International Lending and Debt Problems, H63 - National Debt; Debt Management; Sovereign Debt, and C78 - Bargaining Theory; Matching Theory
Creator: Kehoe, Patrick J. and Perri, Fabrizio Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 621 Abstract:
Previous literature has shown that the study and characterization of constrained efficient allocations in economies with limited enforcement is useful to understand the limited risk sharing observed in many contexts, in particular between sovereign countries. In this paper we show that these constrained efficient allocations arise as equilibria in an economy in which private agents behave competitively, taking as given a set of taxes. We then show that these taxes, which end up limiting risk sharing, arise as an equilibrium of a dynamic game between governments. Our decentralization is different from the existing ones proposed in the literature. We find it intuitively appealing and we think it goes farther than the existing literature in endogenizing the primitive forces that lead to a lack of risk sharing in equilibrium.
Keyword: Risk-sharing, Sustainable equilibrium, Decentralization, Sovereign debt, Enforcement constraints, Default, and Incomplete markets Subject (JEL): F30 - International Finance: General, F34 - International Lending and Debt Problems, E21 - Macroeconomics: Consumption; Saving; Wealth, E32 - Business Fluctuations; Cycles, E44 - Financial Markets and the Macroeconomy, and D50 - General Equilibrium and Disequilibrium: General
Creator: Conesa, Juan Carlos and Kehoe, Timothy Jerome, 1953- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 497 Abstract:
In January 1995, U.S. President Bill Clinton organized a bailout for Mexico that imposed penalty interest rates and induced the Mexican government to reduce its debt, ending the debt crisis. Can the Troika (European Commission, European Central Bank, and International Monetary Fund) organize similar bailouts for the troubled countries in the Eurozone? Our analysis suggests that debt levels are so high that bailouts with penalty interest rates could induce the Eurozone governments to default rather than reduce their debt. A resumption of economic growth is one of the few ways that the Eurozone crises can end.
Keyword: Penalty interest rate, Sovereign debt, Bailout, and Collateral Subject (JEL): F34 - International Lending and Debt Problems, G01 - Financial Crises, and F53 - International Agreements and Observance; International Organizations
Creator: Aguiar, Mark and Amador, Manuel Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 518 Abstract:
We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk and limited commitment to tax plans. The SOE's government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the economy is subject to sovereign debt constraints and the domestic households are impatient relative to the international interest rate. The front loading of tax distortions allows the economy to build a large (aggregate) debt position in the presence of limited commitment. We show that a similar result holds in a closed economy with imperfect inter-generational altruism, providing a link with the closed-economy literature that has explored disagreement between the government and its citizens regarding inter-temporal tradeoffs.
Keyword: Limited commitment, Fiscal policy, and Sovereign debt Subject (JEL): F34 - International Lending and Debt Problems, F38 - International Financial Policy: Financial Transactions Tax; Capital Controls, E62 - Fiscal Policy, and F32 - Current Account Adjustment; Short-term Capital Movements
Creator: Kehoe, Patrick J. and Perri, Fabrizio Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 307 Abstract:
We show how to decentralize constrained efficient allocations that arise from enforcement constraints between sovereign nations. In a pure exchange economy, these allocations can be decentralized with private agents acting competitively and taking as given government default decisions on foreign debt. In an economy with capital, these allocations can be decentralized if the government can tax capital income as well as default on foreign debt. The tax on capital income is needed to make private agents internalize a subtle externality. The decisions of the government can arise as an equilibrium of a dynamic game between governments.
Keyword: Decentralization, Default, Sustainable equilibrium, Incomplete markets, Sovereign debt, Risk-sharing, and Enforcement constraints Subject (JEL): E32 - Business Fluctuations; Cycles, F34 - International Lending and Debt Problems, E21 - Macroeconomics: Consumption; Saving; Wealth, D50 - General Equilibrium and Disequilibrium: General, F30 - International Finance: General, and E44 - Financial Markets and the Macroeconomy
Creator: Cole, Harold Linh, 1957- and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 179 Abstract:
A standard explanation for why sovereign governments repay their debts is that they must maintain a good reputation to easily borrow more. We show that the ability of reputation to support debt depends critically on the assumptions made about institutions. At one extreme, we assume that bankers can default on payments they owe to governments. At the other, we assume that bankers are committed to honoring contracts made with governments. We show that if bankers can default, then a government gets enduring benefits from maintaining a good relationship with bankers and its reputation can support a large amount of borrowing. If, however, bankers must honor their contracts, then a government gets only transient benefits from maintaining a good relationship and its reputation can support zero borrowing.
Keyword: Reputation, Default, and Sovereign debt Subject (JEL): F34 - International Lending and Debt Problems and F30 - International Finance: General
Creator: Aguiar, Mark and Amador, Manuel Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 565 Abstract:
We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are: (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default; both are realistic and standard assumptions in the quantitative literature. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional “lender of last resort” policies.
Keyword: Self-fulfilling debt crises, Multiple equilibria, Sovereign debt, and Debt dilution Subject (JEL): F34 - International Lending and Debt Problems
Creator: Amador, Manuel and Phelan, Christopher Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 564 Abstract:
This paper presents a continuous-time model of sovereign debt. In it, a relatively impatient sovereign government’s hidden type switches back and forth between a commitment type, which cannot default, and an optimizing type, which can default on the country’s debt at any time, and assume outside lenders have particular beliefs regarding how a commitment type should borrow for any given level of debt and bond price. We show that if these beliefs satisfy reasonable assumptions, in any Markov equilibrium, the optimizing type mimics the commitment type when borrowing, revealing its type only by defaulting on its debt at random times. Further, in such Markov equilibria (the solution to a simple pair of ordinary differential equations), there are positive gross issuances at all dates, constant net imports as long as there is a positive equilibrium probability that the government is the optimizing type, and net debt repayment only by the commitment type. For countries that have recently defaulted, the interest rate the country pays on its debt is a decreasing function of the amount of time since its last default, and its total debt is an increasing function of the amount of time since its last default. For countries that have not recently defaulted, interest rates are constant.
Keyword: Reputation, Debt intolerance, Sovereign default, Sovereign debt, Serial defaulters, and Learning Subject (JEL): F34 - International Lending and Debt Problems