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History Remembered: Optimal Sovereign Default on Domestic and External Debt

Author

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  • D'Erasmo, Pablo

    (Federal Reserve Bank of Philadelphia)

  • Mendoza, Enrique G.

    (University of Pennsylvania)

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.

Suggested Citation

  • D'Erasmo, Pablo & Mendoza, Enrique G., 2019. "History Remembered: Optimal Sovereign Default on Domestic and External Debt," Working Papers 19-31, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:19-31
    DOI: https://doi.org/10.21799/frbp.wp.2019.31
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    References listed on IDEAS

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    More about this item

    Keywords

    public debt; sovereign default; debt crisis; European crisis;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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