This paper presents a continuous‐time model of sovereign debt. In it, a relatively impatient sovereign government's hidden type switches back and forth between a commitment type, which cannot default, and an opportunistic type, which can, and where we assume outside lenders have particular beliefs regarding how a commitment type should borrow for any given level of debt and bond price. In any Markov equilibrium, the opportunistic type mimics the commitment type when borrowing, revealing its type only by defaulting on its debt at random times. The equilibrium features a “graduation date”: a finite amount of time since the last default, after which time reputation reaches its highest level and is unaffected by not defaulting. Before such date, not defaulting always increases the country's reputation. For countries that have recently defaulted, bond prices and the total amount of debt are increasing functions of the amount of time since the country's last default. For countries that have not recently defaulted (i.e., those that have graduated), bond prices are constant.

We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy and seeks to insure a risk averse domestic constituency. The expected tax on capital is shown to vary with the state of the economy, generating cyclicality in investment and debt in an environment where the first best capital stock is a constant. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang'' effect. If the government discounts the future at a rate higher than the market, then capital oscillates indefinitely at a level strictly below the first best. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.

Many emerging market economies oscillate between periods of high and low growth (see Aguiar and Gopinath, 2007). These changes in growth regimes generate business cycles that are markedly different from the ones observed in developed countries: consumption and investment are volatile relative to output, and net exports are strongly counter-cyclical. This volatility is often accompanied by sharp changes in the policy environment as well. For example, figure 1 shows the relationship between two measures of expropriation and political risk and real GDP for Argentina between 1984 and 2007. For easy comparison to the GDP series, the risk factors are inverted so that an increase in the index corresponds to a decrease in risk, and all series are normalized to 100 in 1984.1 The risk factor series are highly correlated with output.2 When GDP is higher than average, the institutions and government policies in Argentina foster growth, as measured by increased political stability, enhanced respect for property rights, and stronger contract enforcement. In Aguiar et al. (forthcoming), we develop a framework to understand these policy reversals and the associated economic volatility. In particular, we explore the joint dynamics of sovereign debt, investment, and expropriation risk in a small open economy model. Our departing point from previous work was the introduction of two political economy frictions. ∗Prepared for the January 2009 AEA Annual Meeting. We thank Thomas Sampson for excellent research assistance. 1The measures of risk are taken from Political Risk Services (PRS). The Expropriation Risk Index is a scaled version of the PRS Investment Profile series, which summarizes the government’s attitude toward inward investment based on four risk factors: expropriation, taxation, repatriation, and labor costs. The Political Risk index assigns risk points to a group of factors, of which, the Investment Profile variable is one. Real GDP is from the World Development Indicators. 2The correlation between the inverse measure of expropriation risk and GDP is 0.68, and the political risk and GDP is 0.71.

We study fiscal and monetary policy in a monetary union with the potential for rollover crises in sovereign debt markets. Member-country fiscal authorities lack commitment to repay their debt and choose fiscal policy independently. A common monetary authority chooses inflation for the union, also without commitment. We first describe the existence of a fiscal externality that arises in the presence of limited commitment and leads countries to overborrow; this externality rationalizes the imposition of debt ceilings in a monetary union. We then investigate the impact of the composition of debt in a monetary union, that is the fraction of high-debt versus low-debt members, on the occurrence of self-fulfilling debt crises. We demonstrate that a high-debt country may be less vulnerable to crises and have higher welfare when it belongs to a union with an intermediate mix of high- and low-debt members, than one where all other members are low-debt. This contrasts with the conventional wisdom that all countries should prefer a union with low-debt members, as such a union can credibly deliver low inflation. These findings shed new light on the criteria for an optimal currency area in the presence of rollover crises.