Internal debt crises and sovereign defaults

In this paper we provide a novel explanation of debt crises in emerging markets. In our model, crises arise because of the inability to punish private debtors when many of them default at the same time. We construct an optimal contracting model in which a successful entrepreneur repays the domestic lender yet an unsuccessful one defaults and liquidates his assets. However, the inability to liquidate extensive asset quantities generates the possibility of a second equilibrium with coordinated defaults, in which domestic borrowers find it optimal to default because all other borrowers are also defaulting. During coordinated default crises, the government’s tax collections fall and thus it cannot pay the international lender in full. The model shows that, given tight aggregate constraints on liquidation, joint debt crises are an inevitable part of an optimal response to informational problems in privatesector lending. ∗We thank Katya Kartashova and Jacek Rothert for research assistance, and participants at seminars at the Federal Reserve Banks of New York City and Philadelphia and the International Economics Workshop at Torcuato Di Tella for their comments. The opinions expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Contact us at [email protected] or [email protected].