Default Penalty as a Disciplinary and Selection Mechanism in Presence of Multiple Equilibria

Abstract

Closed exchange and production-and-exchange economies may have multiple equilibria, a fact that is usually ignored in macroeconomic models. Our basic argument is that default and bankruptcy laws are required to prevent strategic default, and these laws can also serve to provide the conditions for uniqueness. In this paper we report experimental evidence on the effectiveness of this approach to resolving multiplicity: society can assign default penalties on fiat money so the economy selects one of the equilibria. Our data show that the choice of default penalty takes the economy close to the chosen equilibrium. The theory and evidence together reinforce the idea that accounting, bankruptcy and possibly other aspects of social mechanisms play an important role in resolving the otherwise mathematically intractable challenges associated with multiplicity of equilibria in closed economies. Additionally we discuss the politico-economic meaning and experimental implications of default penalties that support an active bankruptcy-modified competitive equilibrium.