Reputation and Sovereign Default

In a recent working paper published by the Federal Reserve Bank of Minneapolis, Manuel Amador and Christopher Phelan provide a continuous-time model of sovereign debt. The paper explains how the reputation of a nation is impacted by sovereign debt and evolves over time.

Amador and Phelan's model shows that a government that defaults loses its reputation, but that long periods of borrowing and not defaulting can eventually restore it. During these periods, bond prices are low and default frequencies are high, as in the data. Further, relative to countries that have not recently defaulted, debt levels are low. In their model, as in the data, countries with low debt levels face relatively high interest rates, a phenomenon referred to as “debt intolerance.” In the model, a country can “graduate” into the set of “debt-tolerant” countries by not defaulting for a sufficiently long period of time.