Thursday, December 11, 2008

The costs of default

My work with Eduardo Borensztein on the costs of sovereign default (also here and here) has generated some interest in the blogsphere (here and here). However, I am afraid that some readers are misinterpreting our finding of the presence of a limited cost of default. Traditional economic models base on the seminal paper of Eaton and Gersovitz assume the presence of strategic defaults (i.e., countries default when they could easily pay). We argue that countries don't default strategically but default in the middle of deep crises when paying the debt would imply huge economic and social costs. It is in the presence of such non-strategic (or justifiable) defaults that we observe limited costs of default. We don't know what would happen in the presence of a strategic default. Our conjecture is that the cost of such a strategic default could be huge, and this is why we don't observe strategic defaults (note that our understanding of the literature may soon change as there is now a country which might be on the verge of a strategic default).

A new super cool paper on everything you want to know on sovereign debt and sovereign default will soon be coming. I will post it when it's ready.
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