Debt Forgiveness: the Case for Hyper-Incentive Contracts
We review two proposals for debt forgiveness; the Highly Indebted Poor Country Initiative (HIPC) and the Jubilee 2000 Coalition Initiative (J2K). We then consider the workhorse model of debt forgiveness (Krugman 1988). We show that the workhorse model solution is a sub-optimal contract, where the incentive parameter is set without regard to the cost of effort. A fully-optimal debt-overhang contract is derived, with an incentive parameter greater than the marginal social benefit of extra effort. The so-named Hyper-Incentive Contract eliminates the effects of moral hazard arising from hidden effort, and provides a fuller rationale for case-by-case debt-overhang contracts.
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- Calvo, Guillermo A. & Kaminsky, Graciela L., 1991. "Debt relief and debt rescheduling : The optimal-contract approach," Journal of Development Economics, Elsevier, vol. 36(1), pages 5-36, July.
- Cole, Harold L & Kehoe, Patrick J, 1998. "Models of Sovereign Debt: Partial versus General Reputations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(1), pages 55-70, February.