Open AccessSovereign debt and incentives to default with uninsurable risks
Author(s) -
Bloise Gaetano,
Polemarchakis Herakles,
Vailakis Yiannis
Publication year - 2017
Publication title -
theoretical economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 4.404
H-Index - 32
eISSN - 1555-7561
pISSN - 1933-6837
DOI - 10.3982/te2146
Subject(s) - sovereign default , economics , debt , monetary economics , valuation (finance) , default , sanctions , sovereign debt , sovereignty , finance , politics , political science , law
We show that sovereign debt is unsustainable if debt contracts are not supported by direct sanctions and default carries only a ban from ever borrowing in financial markets even in the presence of uninsurable risks and time‐varying interest rate. This extension of Bulow and Rogoff, 1989 requires that the present value of the endowment be finite under the most optimistic valuation. We provide examples where this condition fails and sovereign debt is sustained by the threat of loss of insurance opportunities upon default, despite the fact that the most pessimistic valuation of the endowment, the natural debt limit, is finite.