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: Bargaining, Sovereign debt, Sovereign default, and Delay Subject (JEL): H63 - National Debt; Debt Management; Sovereign Debt, F34 - International Lending and Debt Problems, and C78 - Bargaining Theory; Matching Theory
Creator: Cole, Harold Linh, 1957- and Kehoe, Timothy Jerome, 1953- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 211 Abstract:
We characterize the values of government debt and the debt’s maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country’s fundamentals place it inside the crisis zone, the government is motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government’s debt. We show that this reduction may be quite gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.
Subject (JEL): H63 - National Debt; Debt Management; Sovereign Debt
Creator: Cole, Harold Linh, 1957-, Dow, James, 1961-, and English, William B. (William Berkeley), 1960- Series: International perspectives on debt, growth, and business cycles Abstract:
We consider a model of international sovereign debt where repayment is enforced because defaulting nations lose their reputation and consequently, are excluded from international capital markets. Underlying the analysis of reputation is the hypothesis that borrowing countries have different, unobservable, attitudes towards the future. Some regimes are relatively myopic, while others are willing to make sacrifices to preserve their access to debt markets. Nations' preferences, while unobservable, are not fixed but evolve over time according to a Markov process. We make two main points. First we argue that in models of sovereign debt the length of the punishment interval that follows a default should be based on economic factors rather than being chosen arbitrarily. In our model, the length of the most natural punishment interval depends primarily on the preference parameters. Second, we point out that there is a more direct way for governments to regain their reputation. By offering to partially repay loans in default, a government can signal its reliability. This type of signaling can cause punishment interval equilibria to break down. We examine the historical record on lending resumption to argue that in almost all cases, some kind of partial repayment was made.
Subject (JEL): H63 - National budget, deficit, and debt - Debt ; Debt management and F34 - International finance - International lending and debt problems
Creator: Cole, Harold Linh, 1957- and Kehoe, Timothy Jerome, 1953- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 210 Abstract:
This paper explores the extent to which the Mexican government's inability to roll over its debt during December 1994 and January 1995 can be modeled as a self-fulfilling debt crisis. In the model there is a crucial interval of debt for which the government, although it finds it optimal to repay old debt if it can sell new debt, finds it optimal to default if it cannot sell new debt. If government debt is in this interval, which we call the crisis zone, then we can construct equilibria in which a crisis can occur stochastically, depending on the realization of a sunspot variable. The size of this zone depends on the average length of maturity of government debt. Our analysis suggests that for a country, like Mexico, with a very short maturity structure of debt, the crisis zone is large and includes levels of debt as low as that in Mexico before the crisis.
Keyword: Sunspot, Debt crisis, and Mexico Subject (JEL): F34 - International Lending and Debt Problems, E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General, and H63 - National Debt; Debt Management; Sovereign Debt
Creator: Miller, Preston J. and Todd, Richard M. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 494 Abstract:
This paper investigates the macroeconomic and welfare effects of a particular public finance decision. That decision was to use debt rather than current taxation to finance deposit insurance payments related to the savings and loan debacle. We find that this decision could have significantly raised real interest rates and affected welfare. The analysis is conducted in a dynamic, open-economy, monetary general equilibrium model in which parameters are set based on empirical observations.
Keyword: Savings and loan, Welfare, Real interest rates, Deposit insurance, Government debt, Public finance, Taxation, and S & L Subject (JEL): H63 - National Debt; Debt Management; Sovereign Debt and G21 - Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Creator: Phelan, Christopher Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 268 Abstract:
This paper presents a government debt game with the property that if the timing of debt auctions within a period is sufficiently unfettered, the set of equilibrium outcome paths of real economic variables given the government has access to a rich debt structure is identical to the set of equilibrium outcome paths given the government can issue only one-period debt.
Subject (JEL): F34 - International Lending and Debt Problems and H63 - National Debt; Debt Management; Sovereign Debt
Creator: Arellano, Cristina, Mateos-Planas, Xavier, and Ríos-Rull, José-Víctor Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 589 Abstract:
In the data sovereign default is always partial and varies in its duration. Debt levels during default episodes initially increase and do not experience reductions upon resolution. This paper presents a theory of sovereign default that replicates these properties, which are absent in standard sovereign default theory. Partial default is a flexible way to raise funds as the sovereign chooses its intensity and duration. Partial default is also costly because it amplifies debt crises as the defaulted debt accumulates and interest rate spreads increase. This theory is capable of rationalizing the large heterogeneity in partial default, its comovements with spreads, debt levels, and output, and the dynamics of debt during default episodes. In our theory, as in the data, debt grows during default episodes, and large defaults are longer, and associated with higher interest rate spreads, higher debt levels, and deeper recessions.
Keyword: Sovereign risk, Emerging markets, Debt crises, and Debt restructuring Subject (JEL): F34 - International Lending and Debt Problems, H63 - National Debt; Debt Management; Sovereign Debt, and G01 - Financial Crises
Creator: Werning, Ivan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 365 Abstract:
We study optimal labor and capital taxation in a dynamic economy subject to government expenditure and aggregate productivity shocks. We relax two assumptions from Ramsey models: that a representative agent exists and that taxation is proportional with no lump-sum tax. In contrast, we capture a redistributive motive for distortive taxation by allowing privately observed differences in relative skills across workers. We consider two scenarios for tax instruments: (i) taxation is linear with arbitrary intercept and slope; and (ii) taxation is non-linear and unrestricted as in Mirrleesian models. Our main result provides conditions for perfect tax smoothing: marginal taxes on labor income should remain constant over time and invariant to shocks. In addition, capital should not be taxed. We also discuss implications for optimal debt management. Finally, an extension highlights movements in the distribution of relative skills as a potential source for variations in optimal marginal tax rates.
Keyword: Time Inconsistency, Capital Taxation, Debt Management, Tax Smoothing, Optimal Taxation, and Redistribution Subject (JEL): E62 - Fiscal Policy, H63 - National Debt; Debt Management; Sovereign Debt, and H20 - Taxation, Subsidies, and Revenue: General
Creator: Hur, Sewon, Kondo, Illenin O., and Perri, Fabrizio Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 574 Abstract:
This paper argues that the comovement between inflation and economic activity is an important determinant of real interest rates over time and across countries. First, we show that for advanced economies, periods with more procyclical inflation are associated with lower real rates, but only when there is no risk of default on government debt. Second, we present a model of nominal sovereign debt with domestic risk-averse lenders. With procyclical inflation, nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. In the absence of default risk, procyclical inflation yields lower real rates. However, procyclicality implies that the government needs to make larger (real) payments when the economy deteriorates, which could increase default risk and trigger an increase in real rates. The patterns of real rates predicted by the model are quantitatively consistent with those documented in the data.
Keyword: Nominal bonds, Inflation risk, Government debt, and Sovereign default Subject (JEL): F34 - International Lending and Debt Problems, E31 - Price Level; Inflation; Deflation, G12 - Asset Pricing; Trading Volume; Bond Interest Rates, and H63 - National Debt; Debt Management; Sovereign Debt