Private Overborrowing under Sovereign Risk

Abstract

This paper argues that excessive international private debt increases the frequency and severity of sovereign debt crises. I develop a quantitative theory of private and public debt that allows me to measure the level of private overborrowing and its effect on the interest rate spread paid on public debt. In an environment where private credit is constrained by the market value of income, individually optimal private borrowing decisions are inefficient at the aggregate level. High private debt increases the probability of a financial crisis. During such crises, drops in consumption cause a decline in the market value of collateral that in turn further reduces consumption. To mitigate this financial amplification mechanism, the government responds with large fiscal bailouts financed with risky external public debt. I show that this response then causes a sovereign debt crisis, characterized by high interest rate spreads and in some cases default. I find that the model is quantitatively consistent with the evolution of international private debt, international public debt, and sovereign spreads in Spain from 1999 to 2015. I estimate that private debt was 5% of GDP above the socially optimal level in the lead-up to the crisis. Private overborrowing increased the annual probability of a financial crisis by 2.4 percentage points. Finally, excessive private debt raised the interest rate spread on public bonds by at least 3.8 percentage points at its peak in 2012.