DP9163 Sovereign default risk and commitment for fiscal adjustment

Author(s):	Carlos Eduardo Gonçalves, Bernardo Guimarães
Publication Date:	October 2012
Keyword(s):	fiscal adjustment, IMF, sovereign debt, sovereign default, time inconsistency
JEL(s):	F33, F34
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=9163

This paper studies fiscal policy in a model of sovereign debt and default. A time-inconsistency problem arises: since the price of past debt cannot be affected by current fiscal policy and governments cannot credibly commit to a certain path of tax rates, debtor countries choose suboptimally low fiscal adjustments. An international lender of last resort, capable of designing an implicit contract that coax debtors into a tougher fiscal stance via the provision of cheap (but senior) lending in times of crisis, can work as a commitment device and improve social welfare.