Discussion of
Optimal Sovereign Defaults
Klaus Adam
Michael Grill
Alberto Martin
CREI, Universitat Pompeu Fabra and Barcelona GSE
March 2013
Motivation
When are sovereign defaults optimal?
Optimal debt policy in a Ramsey model
–small open economy subject to productivity shocks
–both government and international …nancial market issue non-contingent bond
government has commitment
government may default at a cost
Main results
–default may be optimally used to insure against productivity shocks
–calibration
default unlikely to be part of optimal policy against normal business cycle shocks
default may be used to smooth large disaster shocks (e.g. for current US economy, fall of output
30% below trend)
The Model
Small-open economy
–Representative agent with preferences
E0
1
X
t
u(ct)
t=0
with
(1 + r) = 1, i.e. no ‘tilting’motive
–Output given by yt = ztkt
1
c, where zt is stochastic
Benevolent government can trade assets with international …nancial market
–Buy riskless bond from international …nancial market (f )
–Issues non-contingent bonds (b)
The bonds can be defaulted upon: choose to repay (1
The cost of this default is
b
) b
The Issue
In this economy, adverse productivity shocks might be costly:
–all else equal, it requires a reduction in consumption or distortion in investment
–why can’t the economy just borrow itself out of a bad situation? after all, it has commitment!
–there is a ‘natural borrowing limit’that provides a lower bound for wealth
To insure against productivity shocks, the government can
–accumulate foreign assets and run them down in bad times
this precautionary savings does not seem very e¢ cient
if no smoothing is required, consumption is ’wasted’
–default on non-contingent bonds when productivity is low
What prevents the government from issuing contingent assets to begin with? ‘Microfoundations’
–Explicit contract with contingent payment (1
bankers
) b: ex ante cost of
b, i.e. lawyers and/or
–Implicit contingent payment ex post also requires cost
b: agreement might be forgotten, creditor
might take country to court to enforce explicit arrangement
–Ex ante cost paid with certainty, ex post only if state realizes: hence, it is optimal to issue noncontingent bonds and default
Example
Imagine a two period world, t = 1; 2; with endowments
p=
y 2H = 15
1
2
y 1 = 10
1?p =
1
2
Representative agent maximizes,
ln(c1) +
where (1 + r ) = 1.
What is the equilibrium of this economy?
E1 fln(c2)g ,
y 2L = 5
Example
Imagine a two period world, t = 1; 2; with endowments
p=
y 2H = 15
1
2
y 1 = 10
1?p =
1
2
Representative agent maximizes,
ln(c1) +
where (1 + r ) = 1.
E1 fln(c2)g ,
What is the equilibrium of this economy?
–With
= 0: no cost of default, markets are complete
set f = 5, …nanced by issuing explicit promise b = 10
set
L
= 1 and
H
=0
consumption equals 10 at t = 1 and at t = 2 in all states
y 2L = 5
Example
Imagine a two period world, t = 1; 2; with endowments
p=
y 2H = 15
1
2
y 1 = 10
1?p =
1
2
Representative agent maximizes,
ln(c1) +
where (1 + r ) = 1.
E1 fln(c2)g ,
What is the equilibrium of this economy?
–With
= 1: default is e¤ectively impossible
set b = 0, and f > 0 for precautionary savings
in equilibrium, c2H > c1 > c2L
y 2L = 5
Example
Imagine a two period world, t = 1; 2; with endowments
p=
y 2H = 15
1
2
y 1 = 10
1?p =
1
2
y 2L = 5
Representative agent maximizes,
ln(c1) +
where (1 + r ) = 1.
E1 fln(c2)g ,
What is the equilibrium of this economy?
–With
2 (0; 1): some default, but consumption not fully smoothed
set b > 0 and f > 0
some default, some consumption smoothing
Example
Welfare
Welfare
Autarky
1
V
Example...
Of course, this simpli…es what the authors do
–no investment (although this does not seem to matter much)
–no possibility of rolling over (this does)
–in the paper, accumulated wealth is crucial: can consumption smoothing be attained by borrowing
in the low state?
default is only optimal when agent is close to borrowing limit
Calibration results...
–Possibility of default matters most when economy is at its borrowing limit
–By allowing for default, welfare increases because
Default provides additional insurance for consumption
Default relaxes borrowing limit
Default increases the e¢ ciency of investment
–Precisely because it only matters for very high debt ratios, not commonly part of optimal policy to
deal with business cycle shocks
–Disaster risk is a di¤erent matter: for US, given NFA in 2011, optimal default is $3,16 trn should
output fall 30% below trend
Comments
Very interesting paper:
–made me think quite a bit
–very well executed: great craftsmanship!
I have one main comment
–bottom line is somewhat weak compared to the skills on display
–sure, optimal debt policy in Ramsey model with default: this is an unexplored (potentially important)
version of a well-studied model
–but how does it change the way we think about default?
Three possibilities
–Notion that default might raise welfare
–Non-contingent contract might arise endogenously as the result of contracting frictions
–Quantitative/calibration aspects
Default might raise welfare
This is an old idea: by defaulting, individuals (governments) transform the asset span
–Grossman-Van Huyck (1988): excusable defaults
–Dubey, Geanakoplos and Shubik (2001): e¤ects of default in general equilibrium
Default might be bene…cial:
First, an agent who defaults on a promise is in e¤ect tailoring the given security and substituting
a new security that is closer to his own needs, at the cost of a default penalty.
Second, since each agent may be tailoring the same given security to his special needs, one
asset is in e¤ect replaced by as many assets as there are agents, and so the dimension of the
asset span is greatly enlarged.
–More recently, Alfaro and Kanczuk (2005, 2009) and others: why do countries issue debt and
accumulate reserves at the same time?
–Also present in Broner et al (2010): secondary market trading maximizes enforcement, even when it
does not coincide with the commitment solution (which may entail default)
All of this work assumes lack of commitment
Endogenous contract incompletness
The microfoundations for the non-contingent contract are a nice ingredient, but they are not fully
convincing
–It is hard to interpret what it means to “forget the agreement”
–One suggestion in the paper is that creditor might take the country to court to enforce explicit
contract
Doesn’t this imply that the creditor lacks commitment?
–Perhaps more intuitive to think that the state is not directly observable, and there is need to pay a
veri…cation cost
Can’t the government commit to telling the truth?
To push these microfoundations, we would need to have a better sense of
–the exact meaning of commitment
–the precise source of the costs of default
Calibration
On this I don’t have much to say....
Except, you calibrate everything so that the country’s net foreign asset position does not exceed 100%
of GDP
–This is justi…ed by noting that we do not observe higher ratios
–I …nd this a bit arbitrary, though: a country with commitment could presumably go well above that
if it chose to do so
–It could pledge not just output, but also wealth, which is much higher (and which does not play a
role in your model)
Bottom line
Very good paper
But it does not answer the one question I had while reading it: what does commitment bring to the
table?
Literature on default without commitment has established a number of results
–Lack of commitment limits risk sharing and increases consumption volatility. As in this paper, this is
especially true for high debt levels.
–High debt levels distort investment, particularly when output is low (Aguiar et al 2009).
–Contracts may be implicitly state contingent
Grossman and Van Huyck (1988): excusable default
Bulow and Rogo¤ (1989): ex post renegotiation
Quantitative explorations: Aguiar and Gopinath (2006), Arellano (2008)
–
Default happens in bad times
True, they cannot sustain high debt levels, but calibration is quite di¤erent
To be a great paper, you should relate to these results
–especially since the de…ning feature of sovereign debt is that it is hard to enforce
Bottom line
My take: it is true that some countries are better approximated by the model of commitment
–But it is because the bene…ts, and particularly the costs, of default di¤er across countries
–Nondiscrimination and collateral e¤ects of default (Brutti 2010, Broner and Ventura 2011, and
Gennaioli et al. 2012)