Arrow, Kenneth J., “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review, Vol. 53, 1968, pp. 941-73.
Aizenman, Joshua, “Investment, Openness and Country Risk,” National Bureau of Economic Research, Working Paper No. 2410, October 1987.
Baxter, Marianne, “Rational Response to Unprecedented Policies: The 1979 Change in Federal Reserve Operating Procedures,” manuscript, University of Rochester, October 1988.
Calvo, Guillermo A., “Servicing the Public Debt: The Role of Expectations,” American Economic Review, September 1988, pp. 647-61.
Diamond, Douglas W., “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, 51, July 1984, pp. 393-414.
Eaton, Jonathan and Mark Gersovitz, “Debt with Potential Repudiation: Theoretical and Empirical Analysis,” Review of Economic Studies, 48, 1981, pp. 289-309.
Eaton, Jonathan, Mark Gersovitz and Joseph E. Stiglitz, “The Pure Theory of Country Risk.” European Economic Review, 30, 1986, pp. 481-513.
Eichengreen, Barry, and Richard Portes, “Debt and Default in the 1930s: Causes and Consequences,” European Economic Review, 30, 1986, pp. 559-640.
Folkerts-Landau, David, “The Changing Role of International Bank Lending in Development Finance,” International Monetary Fund, Staff Papers, 32, June 1985, pp. 317-63.
Froot, Kenneth, “Buybacks, Exit Bonds, and the Optimality of Debt and Liquidity Relief,” mimeo. 1988; forthcoming in International Economic Review.
Helpman, Elhanan, “Voluntary Debt Reduction: Incentives and Welfare,” National Bureau of Economic Research, Working Paper No. 2692; forthcoming in Staff Papers.
Kaminsky, Graciela, “The Peso Problem and the Behavior of the Exchange Rate. The Dollar Pound Exchange Rate: 1976-1987,” manuscript, University of California, San Diego, November 1988.
Townsend, Robert M., “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economic Theory, 21, October 1979, pp. 265-93.
This paper has benefited from many useful comments on a previous version. I would like to thank, without implicating, Eduardo Borensztein, Max Corden, Michael Dooley and Sara Guerschanik-Calvo.
In some cases moral principles are themselves quite blurry, like when the debt is originally contracted by a de facto government.
The term “moral hazard” has apparently been taken from the insurance literature. It involves situations in which one of the parties could misrepresent the facts.
It is worth mentioning that this type of research appeared in working-paper form before we even heard the first squeaks about the current “debt crisis.”
Notice that this way of looking at the problem abstracts from the coordination issues among creditors that has played such a prominent role in the debt-forgiveness literature (see, e.g., Sachs (1988), Corden (1988), Helpman (1988), Krugman (1988)).
For the present discussion it is enough to divide time into “present” and “future.” “Next period,” then, corresponds to the future.
In reality there are always some assets that could be attached by the lender. Extensions to this case, however, would complicate the analysis with no appreciable gain in economic insight.
Legitimate and illegitimate are just labels. A possible interpretation for a legitimate investment could be just regular investment, while illegitimate investments could be thought as consumption. The latter is obviously much harder to attach than the former.
In case of a tie we assume the country chooses the legitimate activity.
An exception is Calvo (1988) where the penalty is assumed to be an increasing function of the extent of default.
Extensions to account for default at equilibrium are discussed at the end of this section.
This effect must be distinguished from the possible higher penalties that may be involved if each participant in the bank syndicate credibly vowed to exclude a default country from future lending (see Folkerts-Landau (1985)).
We are implicitly assuming that the marginal cost of credit is 1+ρ+γ. This is correct in the present example because, in equilibrium, there will be no default.
Notice that in equilibrium the borrower always chooses legitimate investments and yet, under imperfect monitoring, some loan applications are rejected even when the lender knows that the borrower is perfectly reliable. Thus, if the lender was free to revise the rule, he would accept all loans. This is another example of potential time inconsistency. However, if the borrower anticipated such a revision of the rule, it would always pay him to cheat, and no loans would occur in equilibrium. In a more realistic scenario with heterogeneous borrowers, there will be some role for ex-post monitoring since the penalty may not be enough to deter everybody from cheating. This will allow the capital market to function even when lenders are free to change the rules ex post.
This falls outside the model, but easy extensions would yield this kind of result. For example, we could assume that the lender can choose monitoring accuracy, q, at a cost. Thus, the optimal ex ante contract will endogenize q and C. Ex post, however, once the borrower has taken the loan, incentives change. If C is costless, for example, the lender will be tempted to rely entirely on high C.
This does not apply to our overly simple example in which the borrower has no attachable wealth in the “bad” state, but, as the reader can verify, it would be a feature of more realistic models where some assets can be attached by the lender.
A richer scenario would specify a range of repayment shares with different probabilities. However, the present assumption is enough to illustrate the basic point and, given the complexity involved in actual defaults, the two-options assumption may even be “realistic.”
Data was taken from line 99b.p of International Financial Statistics, various issues.
This is, incidentally, quite remarkable because l-to-3 year GDP cycles are very common in industrialized and other Latin American countries. Similar regressions for other countries yield a Durbin-Watson statistic of 0.25 for the United States and Colombia, 0.85 for Mexico, 0.34 for Chile, 0.39 for Venezuela and 0.19 for the Philippines. Brazil, on the other hand, comes closer to Argentina with a Durbin Watson of 1.32.
Mauro Mecagni of the IMF performed some more sophisticated time series analysis on the Argentine GDP data. He was able to reduce the forecast error somewhat by exploiting the slight serial correlation of the series, but he also found that the distance between actual and forecast GDP during the 1980s exceeded two standard deviations.
It should be remembered that we are talking about contracts which, by definition, are written before the relevant events are known. Thus, although it may be relatively easy to argue after the fact that certain events have occurred (e.g., a return to democracy), the point that I am trying to make is that it may still be very difficult to account for them ex ante by means of variables other than income or some related macroeconomic measures.
This implies, of course, that our arguments for debt relief are entirely independent of the ones given by the above-mentioned literature.