We show how to decentralize constrained efficient allocations that arise from enforcement constraints between sovereign nations. In a pure exchange economy these allocations can be decentralized with private agents acting competitively and taking as given government default decisions on foreign debt. In an economy with capital these allocations can be decentralized if the government can tax capital income as well as default on foreign debt. The tax on capital income is needed to make private agents internalize a subtle externality. The decisions of the government can arise as an equilibrium of a dynamic game between governments.
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Keywords: Incomplete markets; Risk-sharing; Enforcement constraints; Sovereign debt; Decentralization; Sustainable equilibrium; Default $We thank Urban Jermann, Karsten Jeske, Dirk Krueger, and David Levine as well as an anonymous referee and an associate editor for helpful comments and Kathy Rolfe for excellent editorial assistance. Both authors thank the NSF for research support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. *Corresponding author. Fax: +612-204-5515. E-mail address: email@example.com (P.J. Kehoe).
- Enforcement constraints
- Incomplete markets
- Sovereign debt
- Sustainable equilibrium