Sovereign Debt: Is to Forgive to Forget?

The paper is a single theorem and its consequences. The question is what enforces a sovereign loan when, unlike a domestic loan backed by collateral, “the assets that can be appropriated in the event of a foreign sovereign’s default are generally negligible.” The dominant answer at the time, from Eaton and Gersovitz (1981) onward, was reputation: a country borrows because default would tarnish its name and cut it off from world capital markets in future, an answer whose appeal the authors grant is that it “seem[s] robust to institutional detail” – you need not speculate about creditors’ legal rights in their own courts or their ability to get their governments to retaliate. The authors set out “to query reputation-for-repayment theories, not to praise them,” and they do it with an arbitrage argument that needs almost no structure: a small country facing competitive, risk-neutral foreign investors, one infinitely-lived representative agent whose utility is restricted only by preferring more to less, and the assumption that the market value of a claim on the country’s entire future gross income is finite (which rules out Ponzi-type reputational contracts). The decisive observation is that a country which defaults on a purely reputational contract is not actually excluded from world capital markets: it may lose the ability to borrow, but it can still buy state-contingent insurance by paying cash in advance, because the investor’s side of such a contract is enforced by the legal system in the investor’s own country. Theorem 1 then shows that from any node at which reputational debt has positive market value, the country can stop paying and instead fund a sequence of cash-in-advance contracts out of exactly the payments it withholds, satisfying the investors’ break-even condition and the requirement that the country never owe anything ex post, while contributing strictly less than it would have paid – so reputational debt must be non-positive in any sequential equilibrium. Theorem 2 generalises this to the case where creditors can impose direct penalties: lending becomes possible, but the amount is bounded by the expected present value of those penalties alone, and “a good reputation for repaying loans will not in any way enhance a country’s ability to borrow” beyond that bound – which may itself be too generous, “since countries can typically bargain with their creditors.” The only assumption that would save reputational lending is that the country be barred from holding assets abroad, which the authors argue contradicts the premise of the very models they are attacking. They then work through six limitations of the result – reputation spillovers outside the lending relationship, non-competitive lenders, observable-but-not-verifiable shocks, private information, unobservable preferences, and restrictions on the use of reserves – conceding that the private-information case is genuinely unresolved and only conjecturing that the intuition carries over. The conclusions are correspondingly framed as a redirection of research rather than a closed case: enforcement rests on lenders’ legal and political rights, an area the authors call “a gray area of Western law” that “must be studied further,” while “reputation for repayment considerations are at most a secondary factor” – and, answering the title, “debts which are forgiven will be forgotten.”

Jeremy Bulow | Macro Paper Warehouse

Sovereign Debt: Is to Forgive to Forget?