When will solidarity, which emerges spontaneously from the fear of spillovers, be reinforced through contracting? The optimal pact between countries that differ substantially in their probability of distress is a simple debt contract with market financing, a borrowing cap, but no joint liability. While joint liability augments total surplus, the borrowing country cannot compensate the deep-pocket guarantor. By contrast, the optimal pact between two countries symmetrically exposed to shocks with an arbitrary correlation is a simple debt contract with joint liability, provided that shocks are sufficiently independent, spillovers sufficiently large, liquidity needs moderate and available sanctions sufficiently tough.
Sovereign debt; solidarity; joint liability; bailouts;
- E62: Fiscal Policy
- F34: International Lending and Debt Problems
- H63: Debt • Debt Management • Sovereign Debt
American Economic Review, vol. 105, n. 8, 2015, pp. 2333–2363, 33 pages