Series: Working Papers. 1824.
Author: Dominik Thaler.
Published in: Economic Journal. volume 131, issue 635, April 2021, pages 1401–1427
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Abstract
Why do governments borrow internationally, so much as to risk default? Why do they remain
out of financial markets for a while after default? This paper develops a quantitative model
of sovereign default with endogenous default costs to propose a novel and unified answer
to these questions. In the model, the government has an incentive to borrow internationally
due to a difference between the world interest rate and the domestic return on capital, which
arises from a friction in the domestic banking sector. Since banks are exposed to sovereign
debt, sovereign default causes losses for them, which translate into a financial crisis. When
deciding upon repayment, the government trades off these costs against the advantage
of not repaying international investors. After default, it only reaccesses international capital
markets once banks have recovered, because only then are they able to efficiently allocate
the marginal unit of investment again. Exclusion hence arises endogenously. The model
is able to generate significant levels of domestic and foreign debt, realistic spreads,
quantitatively plausible drops of lending and output in default episodes, and periods of postdefault international financial market exclusion of a realistic duration.