Sovereign debt and structural reforms

Müller, Andreas; Storesletten, Kjetil; Zilibotti, Fabrizio

Sovereign debt and structural reforms

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Müller, A, Storesletten, K, Zilibotti, F. Sovereign debt and structural reforms. 2016. handle: http://hdl.handle.net/10230/28283

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Abstract

We construct a dynamic theory of sovereign debt and structural reforms with three interacting frictions: limited enforcement, limited commitment, and incomplete markets. A sovereign country in recession issues debt to smooth consumption and makes reforms to speed up recovery. The sovereign can renege on debt by suffering a stochastic cost, in which case debt is renegotiated. The competitive Markov equilibrium features large fluctuations in consumption and reform effort. We contrast the equilibrium with an optimal contract with one-sided commitment. A calibrated model can match several salient facts about debt crises. We quantify the welfare effect of relaxing different frictions.