History remembered: Optimal sovereign default on domestic and external debt

• Published in: Journal of monetary economics Vol. 117; pp. 969 - 989
• Main Authors: D’Erasmo, Pablo, Mendoza, Enrique G.
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.01.2021
• Subjects: Debt crisis; European crisis; Public debt; Sovereign default; E6; European crisis; Public debt; Debt crisis; E44; H63; F34; Sovereign default
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2020.07.006

•Infrequent but turbulent sovereign defaults on domestic creditors were a ’forgotten history’ in macroeconomics.•We propose a Bewley model in which the government chooses debt and default on domestic and foreign creditors by balancing distributional incentives versus the benefits of debt for self-insurance, liquidity, and risk-sharing.•A feedback mechanism links debt issuance, the debt distribution, the default decision, and risk premia.•Calibrated to Eurozone data, the model is consistent with key long-run and debt-crisis statistics. Defaults are rare and preceded by surging debt and spreads.•Debt sells at the risk-free price most of the time but lack of commitment cuts sustainable debt sharply. Infrequent but turbulent sovereign defaults on domestic creditors were a “forgotten history” in macroeconomics. We propose a Bewley model in which the government chooses debt and default on domestic and foreign creditors by balancing distributional incentives versus the benefits of debt for self-insurance, liquidity, and risk-sharing. A feedback mechanism links debt issuance, the debt distribution, the default decision, and risk premia. Calibrated to Eurozone data, the model is consistent with key long-run and debt-crisis statistics. Defaults are rare and preceded by surging debt and spreads. Debt sells at the risk-free price most often but lack of commitment cuts sustainable debt sharply.