Research Papers
Sovereign Debt and Domestic Economic Fragility. (Job Market Paper)
Recent sovereign default episodes have been associated with substantial output costs. The sovereign's default decision should take into account that debt repudiation may exacerbate such costs. We construct a model where sovereign debt is held by both foreign creditors and domestic residents, and the sovereign is constrained to default equally on the two categories of lenders. Default on foreign lenders bene fits domestic consumption, but default on domestic residents generates an output cost that increases with the extent of the default. This makes the sovereign reluctant to initiate default. We present two sets of results. Firstly, we characterize the optimal default decision and show that full repudiation of debt is not optimal when domestic output costs are sufficiently high. A corollary is that in this model the sovereign can issue debt even in the absence of reputational mechanisms. Secondly, the sovereign finds it optimal to render the domestic economy vulnerable to the adverse effects of default, in order to raise funds cheaply from abroad. Economic fragility is an optimal response to the lack of commitment of the sovereign.
First PDF draft: March 29, 2008.
Presented at MIT: October 1, 2007.
Research in Progress
IMF Crisis Intervention and Moral Hazard.
Government policies that reduce the risk of adverse future events are often costly to implement and difficult to observe. If the government of a country knows that IMF support is available in the event of a crisis, it may exert suboptimal exert ex ante in crisis prevention activities. Moral hazard might arise because IMF intervention improves consumption in the event of a crisis.
We present a framework where IMF crisis intervention ex post can improve government effort ex ante. In the model, government actions to improve economic fundamentals are not always effective, and the government learns of the success of its actions before foreign investors. Without the IMF, foreign investors cannot discriminate between success and failure of the actions until it is too late. The IMF can structure its crisis intervention policy so as to reveal the government's private information to foreign investors. The IMF provides limited transfers to countries which declare themselves to be in a crisis. These countries face high interest rates on international capital markets. Countries which do not accept transfers are identified as having strong fundamentals and are rewarded with low interest rates on international capital markets. The key mechanism is that IMF crisis intervention improves the consumption of non-crisis countries. The difference between consumption in the best and worst states of nature increases, which increases government effort ex ante.
Alternatively, the model framework can be reinterpreted as a model of optimal bailout policy for firms. In this case, the recommendation of the paper is for the government to offer to bail out struggling firms. This policy enables the market to direct financing to those firms that reject government help because they are fundamentally sound. Firms exert higher effort ex ante because the bailout of unsuccessful firms improves the rewards to successful firms.
Presented at MIT: September 15, 2008.
Optimal Crisis Transfers in a Repeated Dual Agency Framework.
The return to foreign direct investment is affected by actions of the host government, but the latter is not party to the contract between foreign lenders and domestic firms. There is a time inconsistency problem because the government undertakes actions after foreign investment is sunk.
We consider an environment where government effort affects the probability of success of the foreigners' investment. The government cannot save or borrow abroad. In a static model, an IMF transfer in the event of crisis (i.e., failure of domestic investments) provides insurance to the country, but it also weakly reduces government effort. In a dynamic model, the size of the transfer can be conditioned on the country's history of economic performance. The model predicts that the government can be induced to exert higher effort if the IMF makes future promised crisis transfers increasing in current economic performance.