Debt Limits and Credit Bubbles in General Equilibrium

Abstract

We provide a novel characterization of self-enforcing debt limits in a general equilibrium framework of risk sharing with limited commitment, where defaulters are subject to recourse (a fractional loss of current and future endowments) and exclusion from future credit. We show that debt limits are exactly equal to the present value of recourse plus a credit bubble component. We provide applications to models of sovereign debt, private collateralized debt, and domestic public debt. Implications include an original equivalence mapping among distinct institutional arrangements, thereby clarifying the relationship between different enforcement mechanisms and the connection between asset and credit bubbles.

Climate Defaults and Financial Adaptation

“…Our paper also integrates best estimates of cyclone damages from the empirical climate economics literature, including Nordhaus (2010), Mendelsohn et al (2012), Hsiang and Jina (2014), Hsiang and Jina (2015), and Bakkensen and Barrage (2022). 4 Our paper connects the climate economics literature to the growing literature on sovereign default, including Eaton and Gersovitz (1981), Bulow and Rogoff (1989), Aguiar and Gopinath (2006), Arellano (2008), Yue (2010), Mendoza and Yue (2012), Bai and Zhang (2012), Chatterjee and Eyigungor (2015), Hatchondo et al (2016), Phan (2016Phan ( , 2017b, Park (2017), Dovis (2019), Bianchi et al (2019), Joo (2020), andda Rocha et al (2022). 5 A related paper is Mallucci (2022), which introduces hurricane risk and CAT bonds into a quantitative endowment economy framework with long-term debt carefully calibrated to a sample of Caribbean countries and provides a refined discussion of the impact of disaster risk on spreads.…”