Default and efficient debt markets

We examine the nature of debt contracts when repayment of debt cannot be fully enforced. We study outcomes an infinite-horizon economy in which some individuals have access to a productive, intertemporal technology. Individuals without access to the technology must lend their savings to the rest. Borrowers can default on their debt at any time: lenders can capture a fraction of their investment incomes. Borrowers who default stand to lose the right to borrow in the future. These constitute the penalties of capture and exclusion. We evaluate debt and repayment paths that can be sustained in this these penalties. The set of allocations that can be supported by default-free debt is fully characterized; this set is non-empty, convex, and contains a subset that is fully efficient. We then evaluate the role of debt contracts in decentralizing constrained optima. Debt contracts that involve two-part pricing are shown to support efficient allocations subject to the no-default constraint. Efficiency is compatible with anonymous contracts. © 2002 Elsevier Science B.V. All rights reserved. JEL classification: C61; D92; E2