DP19545 Structural Reforms in the Shadow of Debt Overhang: A Quantitative Perspective
We document a hump-shaped relationship between sovereign debt and economic reforms, which motivates our theory of sovereign debt and structural reforms. We highlight three frictions: limited commitment (default risk), moral hazard in reforms, and incomplete financial markets (absence of GDP-linked debt). While debt smooths consumption, accumulating debt creates “debt overhang,” reducing reform incentives. Our calibrated model replicates empirical patterns in reforms, debt dynamics, and renegotiation. We quantify the welfare costs of these frictions, finding that financial development improves consumption smoothing but worsens moral hazard. We uncover an important complementarity: effective policies must address both market incompleteness and moral hazard simultaneously.
