Efficient frameworks for sovereign borrowing

Gregor Irwin and Gregory Thwaites
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Gregor Irwin: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Gregory Thwaites: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH

No 343, Bank of England working papers from Bank of England

Abstract: This paper presents a theoretical model of strategic default to assess how national and international policymakers should seek to influence the cost of default and the distribution of bargaining power in the event of a default. We find that, in the absence of restrictions on the parameter space, deadweight costs of default should be driven to zero. Moreover, if the debtor is risk-averse, there is an optimal division of bargaining power between the debtor and its creditors. Even with restrictions on the parameter space, marginally lower deadweight costs, possibly in some combination with greater creditor bargaining power, can always raise social welfare ex ante. However, once debt has been contracted, the debtor's trade-off between creditor bargaining power and deadweight costs changes fundamentally. In equilibrium, the deadweight costs of default may therefore tend to be too high, and the allocation of bargaining power inefficiently skewed towards the debtor. The challenge for policymakers is to find credible, time-consistent combinations of policies that can both reduce deadweight costs and shift bargaining power towards creditors.

Keywords: Sovereign debt; default; restructuring. (search for similar items in EconPapers)
JEL-codes: F34 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-reg
Date: 2008-03

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Persistent link: http://EconPapers.repec.org/RePEc:boe:boeewp:0343

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