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Financing vs. Forgiving a Debt Overhang

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  • Paul R. Krugman

Abstract

This paper examines the tradeoffs facing creditors of a country whose debt is large enough that the country cannot attract voluntary new lending. If the country is unable to meet its debt service requirements out of current income, the creditors have two choices. They can finance the country, lending at an expected loss in the hope that the country will eventually be able to repay its debt after all; or they can forgive, reducing the debt level to one that the country can repay. The post-1983 debt strategy of the IMF and the US has relied on financing, but many current calls for debt reform call for forgiveness instead. The paper shows that the choice between financing and forgiveness represents a tradeoff. Financing gives the creditors an option value: if the country turns out to do relatively well, creditors will not have written down their claims unnecessarily. However, the burden of debt distorts the country's incentives, since the benefits of good performance go largely to creditors rather than itself. The paper also shows that the tradeoff itself can be improved if both financing and forgiveness are made contingent on states of nature that the country cannot affect, such as oil prices, world interest rates, etc.

Suggested Citation

  • Paul R. Krugman, 1988. "Financing vs. Forgiving a Debt Overhang," NBER Working Papers 2486, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:2486
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    References listed on IDEAS

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    1. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-178, February.
    2. Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435, National Bureau of Economic Research, Inc.
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