Strategic default

This paper analyzes the incentives to strategically default in a dynamic principal-agent model with hidden savings and one-sided limited commitment. The agent's outside option depends on the hidden savings, therefore the principal cannot observe the agent's incentives to default. The agent has a trade-off between activities that increase the value of the partnership and activities that increase the value of default. The principal renegotiates the contract each time the incentive to default is larger than the incentive to stay in the partnership. In order to be able to renegotiate, it must make sure that current savings are truthfully revealed, and effort is incentive compatible. I show that the optimal incentive-compatible allocation is unique and time consistent. This is in striking contrast with Marimon and Rendahl (2009) that analyzes a similar model with full information and show that multiple equilibria arise, with most of them being time-inconsistent. The reason for uniqueness in a private information environment is that incentive compatibility links default incentives intertemporally, while this does not happen in a model with full information. Numerical examples illustrate the dynamic properties of the optimal allocation.