Federal Reserve Bank of Minneapolis Research Department Sta ff Report 307 Revised September 2003 Competitive Equilibria With Limited Enforcement

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. ∗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. Here we study equilibria in economies in which there is limited ability to enforce credit arrangements between sovereign nations. In previous work (Kehoe and Perri [12]), we have discussed how this limited ability manifests itself in enforcement constraints which require that in each period and state, allocations can be enforced only if their value is greater than it would be if the country were excluded from all further intertemporal and interstate trade. This friction captures in a simple way the difficulties of enforcing contracts between sovereign nations that involve large transfers of resources backed only by promises to repay. This type of friction turns out to be useful to explain the international macroeconomic comovements. Our recent work focuses on planning problems with enforcement constraints, or constrained efficient allocations, but does not analyze in detail how these allocations can be decentralized. Here we do that detailed analysis. We follow the literature on sovereign debt in assuming that the decision to partially or completely default on foreign debt is made by the government of the borrowing country, the domestic government. We abstract completely from any incentive of private agents to default. The assumptions of the sovereign debt literature are motivated by historical experience. Foreign creditors cannot easily use the domestic legal system to pursue legal claims against borrowers who do not repay their loans. Therefore, international loans typically involve the domestic government. Either the loans are made directly to the government, which then relends the funds through a domestic intermediary, or the loans are nominally made directly to private entities, like firms, banks, and private households, but the government guarantees the collection of debt and the repayment to foreigners. Either way, it is the government and not a private agent that decides to default on loans to foreigners. Of course, private agents can decide to default on their obligations to the government just as they can default on their obligations to other domestic agents. These private defaults are subject to the domestic legal system, and we abstract from them, as does most of the sovereign debt literature, in order to focus the attention on the international elements. (See the survey by Eaton and Fernandez [7] for a further discussion of the empirical motivation for these assumptions.1) In our economy, we model partial or complete default on foreign debt as a decision of the