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Sovereign Debt, Risk Sharing, and Austerity Programs

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  • Kjetil Storesletten

    (University of Oslo)

  • Fabrizio Zilibotti

    (University of Zurich)

  • Andreas Mueller

    (University of Oslo)

Abstract

We construct a dynamic model of sovereign debt related to Arellano (2008), where the economy's aggregate income and the cost of default is stochastic, and the outstanding debt is periodically renegotiated in equilibrium as in Bulow and Rogoff (1989). Like in Krugman (1989), in a recession the sovereign can provide effort to increase the probability of recovery, however part of the gains of good performance will go to the creditors, causing moral hazard. We characterize analytically the equilibrium in terms of the price of the non state-contingent sovereign debt, the probability of renegotiation and the consumption and reform effort dynamics. We find that during a recession, in the decentralized equilibrium, the government's limited commitment to repay the sovereign debt induces excessive consumption volatility in comparison to the constrained optimal allocation. Moreover, the government underprovides reform effort, thus the expected duration of the recession is too long compared to the first-best as well as the second-best allocation. This inefficiencies leave potential for external intervention. To this end, we study a small open economy in a persistent recession with an endogenous probability of recovery (let's say Greece), and evaluate the effect of several assistance programs run by an international authority (e.g., the IMF, ECB, or the EU) that can provide a guarantee for the repayment of the sovereign debt conditional on repeated compliance, and possibly fiscal austerity and reform effort. We find that successful assistance programs require reform effort control, and allow the debtor to renegotiate terms whenever conditions favor leaving the program. The welfare losses caused by ill-designed assistance programs can be substantial.

Suggested Citation

  • Kjetil Storesletten & Fabrizio Zilibotti & Andreas Mueller, 2015. "Sovereign Debt, Risk Sharing, and Austerity Programs," 2015 Meeting Papers 1066, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:1066
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