Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default

Abstract

Europe's debt crisis resembles historical episodes of outright default on domestic public debt about which little research exists. This paper proposes a theory of domestic sovereign default based on distributional incentives affecting the welfare of risk-averse debt and nondebtholders. A utilitarian government cannot sustain debt if default is costless. If default is costly, debt with default risk is sustainable, and debt falls as the concentration of debt ownership rises. A government favoring bondholders can also sustain debt, with debt rising as ownership becomes more concentrated. These results are robust to adding foreign investors, redistributive taxes, or a second asset.

Sovereign Debt and Financial Crises: Theory and Historical Evidence

“…One reason why so much attention has been focused on the case of external lenders is that “us versus them” strategic interactions are easier to model. In the case of domestic debt, Pablo D'Erasmo and Enrique Mendoza () tackle this issue—in “Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default”—by assuming that wealth is distributed unequally between debt holders and nonholders. However, these authors find that if the government is utilitarian, then there is no equilibrium with debt.…”

The Public Debt Crisis of the United States

“…This assumption, however, seems questionable in light of the findings documented in the previous three sections. Hence, in this section, we explore the implications of relaxing this assumption following the work by D'Erasmo and Mendoza () which studies conditions under which a government chooses optimally to default on its domestic public debt. The interest on this issue stems also from the seminal work by Reinhart and Rogoff (), which documents episodes of de‐jure (or outright) domestic defaults in a cross‐country historical dataset including advanced and developing countries.…”

“…D'Erasmo and Mendoza () study optimal domestic debt issuance and default decisions of a utilitarian government that cannot commit to repay its debt. The government faces a stochastic process of government expenditures and levies an income tax paid at the same rate by all individuals.…”

“…We describe next some of the key elements of the D'Erasmo‐Mendoza setup to clarify the above arguments. The complete analysis can be found in D'Erasmo and Mendoza (). There is a continuum of agents in the economy that face idiosyncratic income shocks ( ) and an aggregate government expenditure shock ( ).…”

“…World markets would be exposed to a sharp drop in government bond prices and a sudden reversal of fortunes in the ability of governments to sustain high debt ratios without fiscal adjustment. In light of the previous three arguments, the risk of a default on domestic public debt, even an outright default, should not be ignored. Recent work by D'Erasmo and Mendoza () shows that a utilitarian government may choose to default if the social cost of the regressive redistribution imposed by repaying exceeds the social value of public debt as a financial asset that provides liquidity, a vehicle for self‐insurance, and a mechanism for sharing of idiosyncratic risk across agents.…”