This paper surveys the literature on sovereign debt from the perspective of understanding how sovereign debt differs from privately issued debt, and why sovereign debt is deemed safe in some countries but risky in others. The answers relate to the unique power of the sovereign. Control over its territory and most of its assets can make debt enforcement difficult, while the power to tax serves as a substitute for collateral, making debt relatively safe. The paper discusses debt contracts and the sovereign debt market, sovereign debt restructurings, and the empirical and theoretical literatures on the costs and causes of defaults. It describes the adverse impact of sovereign default risk on the issuing countries and what explains this impact. The survey concludes with a discussion of policy options to reduce sovereign risk, including fiscal frameworks that act as commitment devices, state-contingent debt, and independent and credible monetary policy.
We study the interaction between sovereign risk and aggregate demand driven by the endogenous response of savers to sovereign risk. We obtain two main results. First, this new sovereign risk / aggregate demand channel creates a tradeoff between the recessionary impact of fiscal consolidation and the risk of a future sovereign debt crisis. Risk aversion has a large impact on output losses and on welfare when sovereign debt is risky. Second, we find that savers and borrowers disagree about the optimal path of sovereign deleveraging. The sovereign risk channel can therefore explain some of the rise in political disagreement about fiscal policy. Using a version of the model calibrated to the Eurozone crisis, we find that sovereign risk justifies starting to deleverage about two years after the beginning of the recession. We also find that, after 2012, the channel was weakened so that active deleveraging in a recession is no longer justified.
We revisit some of the contributions of Roberto Frenkel's (1979) classic paper in a modern setting. We are interested in situations in which higher uncertainty about future inflation induces firms to increase markups. It turns out that, although a simple CES model predicts the opposite, markups do increase in response to uncertainty when minimum (or maximum) capacity and liquidity constraints are considered.