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  • Sovereign Debt and Structural Reforms�

    Andreas Müllery Kjetil Storeslettenz Fabrizio Zilibottix

    September 11, 2016


    Motivated by the European debt crisis, we construct a tractable theory of sovereign debt and structural reforms under limited commitment. A sovereign country which has fallen into a recession of an uncertain duration issues one-period debt to smooth consumption. It can also implement structural policy reforms to speed up recovery from the recession. The sovereign can renege on its debt obligations by su¤ering an observable stochastic default cost, in which case creditors o¤er a take-it-or-leave-it debt haircut to avert default. The laissez-faire Markov equilibrium features large uctuations in consumption, debt, and reform e¤ort. During the recession, consumption falls whenever debt is honored. A large debt destroys incentives for structural reforms since some of the gains from reform accrue to the lenders. Allowing for nancial markets with state-contingent debt provides only limited consumption insurance. We contrast the Markov equilibrium with an optimal contract with one-sided commitment. This allocation, which features step-wise increasing consumption and step-wise decreasing reform e¤ort, can be interpreted as a exible assistance program provided by an international institution with commitment. We calibrate the model and show that it can match a number of key stylized facts about debt and debt crises. We quantify the e¤ect of relaxing di¤erent contractual and nancial frictions. JEL Codes: E62, F33, F34, F53, H12, H63 Keywords: Austerity, Debt overhang, Default, European debt crisis, Fiscal policy, Great Re-

    cession, Limited commitment, Markov equilibrium, Moral hazard, Renegotiation, Risk premia, Risk sharing, Sovereign debt, Structural reforms.

    �We would like to thank Manuel Amador, George-Marios Angeletos, Cristina Arellano, Marco Bassetto, Tobias Broer, Fernando Broner, Alessandro Dovis, Jonathan Eaton, Patrick Kehoe, Enrique Mendoza, Juan-Pablo Nicolini, Ugo Panizza, Aleh Tsyvinski, Jaume Ventura, Christopher Winter, Tim Worrall, and seminar participants at Annual Meeting of the Swiss Society of Economics and Statistics, Barcelona GSE Summer Forum, Brown University, CEMFI, Columbia University, CREi, EIEF Political Economy Workshop, ESSIM 2016, European University Institute, Goethe University Frankfurt, Graduate Institute of Geneva, Humboldt University, Istanbul School of Central Banking, NOR- MAC, Oxford, Royal Holloway, Swiss National Bank, Università Cà Foscari, Universitat Autonoma Barcelona, University College London, University of Cambridge, University of Konstanz, University of Oslo, University of Oxford, University of Pennsylvania, University of Padua, University of Toronto, University of Zurich, and Yale University. We acknowledge support from the European Research Council (ERC Advanced Grant IPCDP-324085).

    yUniversity of Oslo, Department of Economics, zUniversity of Oslo, Department of Economics, xUniversity of Zurich, Department of Economics,

  • 1 Introduction

    Sovereign debt crises and economic reforms have been salient intertwined policy issues throughout the Great Recession, especially in Europe. Economic theory o¤ers two simple policy prescriptions for countries su¤ering a temporary decline in output. First, they should borrow on international markets to smooth consumption. Second, they should undertake reforms possibly painful in the short run to speed up economic recovery. However, these simple policy prescriptions run into di¢ culties in the presence of limited enforcement issues. On the one hand, risk sharing may be hampered by rising default premia associated with the risk of debt renegotiations.1 On the other hand, a large debt can reduce the borrowers incentive to undertake economic reforms to boost economic growth since some of the gains from growth would accrue to the lenders.

    To cast light on these trade-o¤s and to derive positive and normative predictions, this paper pro- poses a dynamic theory of sovereign debt that rests on four building blocks. The rst is that sovereign debt is subject to limited enforcement, and that countries can renege on their obligations subject to real costs, as in e.g. Aguiar and Gopinath (2006), Arellano (2008) and Yue (2010). Departing from the previous literature, we assume the size of default costs to be stochastic, reecting exogenous changes in the domestic and international situation. The second building block is that whenever creditors face a credible default threat, they can make a take-it-or-leave-it renegotiation o¤er to the indebted coun- try. This approach conforms with the empirical observations that unordered defaults are rare events, and that there is great heterogeneity in the terms at which debt is renegotiated, as documented by Tomz and Wright (2007) and Sturzenegger and Zettelmeyer (2008). The third building block is the possibility for the government of the indebted country to make structural policy reforms that speed up recovery from an existing recession. Examples of such reforms include labor and product market deregulation, and the establishment of scal capacity that allows the government to raise tax revenue e¢ ciently (see, e.g., Ilzkovitz and Dierx 2011). While these reforms are benecial in the long run, they may entail short-run costs for citizens at large, governments or special-interest groups (see, e.g., Blanchard and Giavazzi 2003, and Boeri 2005). The fourth building block is the assumption that mar- kets nd it di¢ cult to coordinate punishment for past bad behavior of governments. More precisely, markets charge a high interest rate on highly indebted countries, but have no additional instrument to discipline, ex-post, non-virtuous governments. This idea is captured by the notion of a Markov-perfect equilibrium, which excludes reputational mechanisms.

    More formally, we construct a dynamic model of an endowment economy subject to income shocks following a two-state Markov process. A benevolent local government can issue sovereign debt to smooth consumption. The country starts in a recession of an unknown duration. The probability that the recession ends is endogenous, and hinges on the governments reform e¤ort. Debt issuance is subject to a limited-commitment problem: the government can, ex-post, repudiate its debt, based on the publicly observable realization of a stochastic default cost. When this realization is su¢ ciently low relative to the outstanding debt, the default threat is credible. In this case, a syndicate of creditors makes a take-it-or-leave-it debt haircut o¤er, as in Bulow and Rogo¤ (1989). In equilibrium, there is no outright default, but debt renegotiations. Haircuts are more frequent during recession, and more frequent the larger is the outstanding sovereign debt. Consumption increases after a renegotiation, in

    1Greece, the hardest hit country in Europe, saw its debt-GDP ratio soar from 107% in 2008 to 170% in 2011, at which point creditors had to agree to a debt haircut implying a 53% loss on its face value. Meanwhile, international organizations stepped in to provide nancial assistance and access to new loans, asking in exchange scal austerity and a commitment to economic reforms. A new crisis with a request from the Greek government of a haircut on the outstanding debt was barely averted in the summer of 2015.


  • line with the empirical evidence that economic conditions improve in the aftermath of debt relief, as documented in Reinhart and Trebesch (2016).

    We rst characterize the laissez-faire equilibrium. During recessions, the government would like to issue debt in order to smooth consumption. However, as debt accumulates, the probability of renegotiation increases, implying a rising risk premium and consumption volatility. The reform e¤ort exhibits a non-monotonic pattern: it is increasing with debt at low levels of debt because of the disciplining e¤ect of recession. However, for su¢ ciently high debt levels the relationship is ipped because of a debt overhang problem: very high debt levels deter useful reforms because most of the gains from the reforms accrue to foreign lenders in the form of capital gains on the outstanding debt. The moral hazard problem exacerbates the countrys inability to achieve consumption smoothing: at high debt levels, creditors expect little reform e¤ort, are pessimistic about the economic outlook, and request an even higher risk premium. We also consider an economy in which the government can issue debt whose payment is contingent on the stochastic realization of the endowment. We show that even in this case, the moral hazard in reform e¤ort prevents full insurance.2

    Next, we characterize the dynamic principal-agent problem when the planner, contrary to investors in the competitive equilibrium, can commit to punish the agent (i.e., the sovereign government) when she deviates from the optimal contract. However, the enforcement power is limited: the agent to quit permanently the contract and resort to the competitive (Markov) equilibrium after paying the default cost. When this happens (out of equilibrium), the planner can exclude permanently the agent from future contractual relations. In other words, the agent can benet from the principals commitment power that the market lacks. However, there is only one opportunity to be in the contract. If the agent quits, it is for good. We consider two alternative cases. In the rst, the planner can observe (as do investors in the competitive equilibrium) the reform e¤ort. In the second, the planner cannot observe it. The optimal contract with observable e¤ort is very di¤e


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