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Optimal Sovereign Default

  • Adam, Klaus
  • Grill, Michael

When is it optimal for a government to default on its legal repayment oblig- ations? We answer this question for a small open economy with domestic production risk in which the government optimally finances itself by issuing non-contingent debt. We show that Ramsey optimal policies occasionally devi- ate from the legal repayment obligation and repay debt only partially, even if such deviations give rise to significant default costs. Optimal default improves the international diversification of domestic output risk, increases the efficiency of domestic investment and - for a wide range of default costs - significantly increases welfare relative to a situation where default is simply ruled out from Ramsey optimal plans. We show analytically that default is optimal following adverse shocks to domestic output, especially for very negative international wealth positions. A quantitative analysis reveals that for empirically plausible wealth levels, default is optimal only in response to disaster-like shocks to do- mestic output, and that default can be Ramsey optimal even if the net foreign asset position is positive.

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Paper provided by University of Mannheim, Department of Economics in its series Working Papers with number 12-16.

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Date of creation: 2012
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Handle: RePEc:mnh:wpaper:32508
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  12. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, pages 519-546.
  13. Zame, William R, 1993. "Efficiency and the Role of Default When Security Markets Are Incomplete," American Economic Review, American Economic Association, vol. 83(5), pages 1142-64, December.
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  17. Sims, Christopher A, 2001. "Fiscal Consequences for Mexico of Adopting the Dollar," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 597-616, May.
  18. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, Oxford University Press, vol. 121(3), pages 823-866.
  19. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
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