The Greek debt crisis: Excusable vs. strategic default

Abstract

The Greek debt crisis revealed that sovereign default is not limited to emerging and developing countries. Can we take the strategic default model, developed for emerging markets, and recalibrate it to explain the crisis in Greece? The Greek economy differs from an emerging market in having higher government debt relative to GDP, counter-cyclical government debt, and consumption smoother than income. Our recalibrated strategic default model matches the high debt/GDP, but it misses the other two features of advanced countries. And it fails to generate a crisis. We propose an alternative model, replacing the absence of commitment to repay with commitment. Default occurs due to inability to repay and is excusable. Our alternative model of excusable default allows us to match the behavior of debt and the spread as the crisis approaches, as well as key features of business cycles in advanced countries. It also generates a crisis with correct timing.