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The Dynamics of Sovereign Debt: Smoothing and Impatience

We consider the allocation of resources between a borrower and lender in the absence of third-party enforcement of loan contracts. The two parties differ in two respects: (1) The borrower is risk averse and subject to fluctuations in endowments while the lender is risk neutral. (2) The borrower discounts the future at a higher rate than the lender. The first difference provides a consumption-smoothing motive for borrowing and the second a long-term impatience motive for borrowing. In contrast to a situation in which only the first effect operates, sovereignty constraints preclude the unconstrained Pareto optimal allocation. However, the relationship provides sufficient surplus to each party to sustain some lending. The constrained allocation can imply a negative correlation between change in indebtedness and consumption. The equilibrium is supported by the renegotiation-proof and coalition-proof punishments demonstrated by Kletzer and Wright (2000).