The aftermath of sovereign debt crises: a narrative approach

Default is as old as sovereign debt. Since 1820, sovereigns have spent 18% of time in a state of default. Despite the scale of the problem, the causes and consequences of defaults are still imperfectly understood. In this paper we quantify the aggregate cost of defaults, based on a sample of 50 sovereigns between 1870 and 2010. Since defaults are endogenous to the business cycle, we use the narrative approach to identify plausibly exogenous episodes. We find significant and persistent costs of defaults starting at 1.6% of GDP and peaking at 3.3% before recovering to the pre-crisis level after five years. Moreover, we identify a large heterogeneity of costs by the cause of default. Higher costs are associated with defaults initiated by negative supply shocks, political crises, or adverse terms of trade. In contrast, domestic demand shocks have a moderate effect that is quickly reversed.