Strategic Default with an Exit Decision

Abstract

In 2010 Greece became the first advanced country to enter a sovereign default crisis. Preceding the crisis, debt relative to GDP was high and counter-cyclical, and consumption was smoother than income. Debt spiked just prior to the crisis. These dynamics are counter to the predictions of the standard strategic default model, which was developed to explain crises emerging markets. To match this behavior, we extend the strategic default model by endogenizing the sovereign's decision to exit default and reenter capital markets. We assume that exit requires payment of a recovery value based ability to pay, consistent with IMF guidelines that a sovereign default negotiate in good faith. We assume that a sovereign default must choose whether to repay recovery value and exit, characterizing an excusable default, or to repay nothing and continue default with the standard punishments, a strategic default. We identify the Greek default as excusable, and match Greek debt behavior leading to the crisis and business-cycle moments.