Economic Theory
Abstract
This paper studies how sovereign default can affect productivity and output, using a continuous-time model in which the government chooses whether to service its debt and default changes the future productivity process. The model is calibrated with financial-market information for ten European countries during 2009–2012, when stock prices and sovereign risk premiums moved inversely. For a pooled, representative country, the calibration implies that markets price in a 3.70% decline in total factor productivity; averaging country-specific estimates yields a 5.88% decline. The model predicts an output contraction of about 3.71% for a typical debt crisis. The authors use the framework to examine crisis dynamics, recovery, fiscal policy, and how default incentives vary with initial debt.