We document that countries partially default often and with varying intensity, resulting in lengthy episodes and hump-shaped patterns for partial default and debt. Default episodes lead to haircuts for lenders but not to reductions in debt, because the defaulted debt accumulates and borrowing continues. We present a theory of partial default rationalizing these patterns and the heterogeneity of partial default, and partial default’s comovements with spreads, debt, and output that are absent in standard sovereign default theory. We include policy counterfactuals in the form of pari passu and no-dilution clauses and debt-relief policies, and their welfare implications.

Global financial imbalances can result from financial integration when countries differ in financial markets development. Countries with more advanced financial markets accumulate foreign liabilities in a gradual, long-lasting process. Differences in financial development also affect the composition of foreign portfolios: countries with negative net foreign asset positions maintain positive net holdings of nondiversifiable equity and foreign direct investment. Three observations motivate our analysis: (1) financial development varies widely even among industrial countries, with the United States on top; (2) the secular decline in the U.S. net foreign asset position started in the early 1980s, together with a gradual process of international financial integration; (3) the portfolio composition of U.S. net foreign assets features increased holdings of risky assets and a large increase in debt.

We show that a theory of earnings and wealth inequality, based on the optimal choices of ex ante identical households that face uninsured idiosyncratic shocks to their endowments of efficiency labor units, accounts for the U.S. earnings and wealth inequality almost exactly.