Self-enforcing Debt, Reputation, and the Role of Interest Rates

Abstract

How domestic costs of default do interact with the threat of exclusion from credit markets to determine interest rates and debt sustainability? In this paper, we address this question in the context of a stochastic general equilibrium model with lack of commitment and self-enforcing debt, where the costs from default consist of two components: loss of access to international borrowing and output costs. In contrast to Bulow and Rogoff (1989), we show that part of the ability to borrow is merely attributed to the threat of credit exclusion, or equivalently, to the loss of the sovereign's reputation. Apart from the limit case analyzed by Hellwig Lorenzoni (2009) where output costs are absent, equilibrium interest rates are always higher than growth rates, implying that the way "reputation for repayment" supports debt does not depend on whether debt limits allow agents to exactly roll over existing debt period by period. When exclusion is the only consequence of default, we also show that a sovereign's "natural ability to repay'' is not essential for debt sustainability. We identify a new channel where the creditworthiness of a sovereign reflects its crucial role as a financial intermediary. Co-author: Yiannis Vailakis (U. of Glasgow)