International Financial Integration,
Sovereignty, and Constraints on
Macroeconomic Policies
Kenneth Kletzer

This paper considers the consequences of international financial market
integration for national fiscal and monetary policies that derive fromthe absence of an international sovereign authority to define and enforce
contractual obligations across borders. The sovereign immunity of national
governments serves as a fundamental constraint on international financeand is used to derive intertemporal budget constraints for sovereign nations
and their governments. It is shown that the appropriate debt limit fora country allows for state-contingent repayment. With non-contingent
debt instruments, debt renegotiation occurs in equilibrium with positive
probability. A model of tax smoothing is adopted to show how information
imperfections lead to conventional bond contracts that are renegotiatedwhen a critical level of indebtedness is reached. Renegotiation is interpreted
in terms of nominal and real denominated bonds drawing implications
for the intertemporal borrowing constraint for monetary policies, theaccumulation of reserve assets, and current account sustainability.
Keywords: International financial integration; Sovereignty; Tax smoothing;
Nominal public debt; Monetary policy
JEL Classification: E60, F40, H60

University of California, Santa Cruz (E-mail: kkletzer@ucsc.edu)
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION.

165

I. Introduction
International financial integration restricts the capacity of national authorities to use
fiscal, financial, and monetary policies to influence domestic economic performance.
In an integrated financial market, government debt competes for world savingsand fiscal authorities do not enjoy a captive supply of domestic savings for financing
public expenditures. Lax financial-sector policies can be severely punished byinternational financial markets, and external real and monetary disturbances
impact monetary policymaking. International financial integration can eliminate
opportunities for financial repression in liberalizing economies, exposing publicfinance and monetary policies to the discipline of a competitive capital market.
On the other hand, global capital market integration can broaden the base forgenerating revenues from seigniorage and unanticipated inflation taxes for advanced
industrialized economies.
This paper considers the appropriate constraints on national fiscal and monetary
policies in an integrated financial market that derive from the absence of an international sovereign authority to define and enforce contractual obligations acrossborders. International public borrowing is possible to the extent that debt issuers
restrain their exercise of sovereign immunity. While sovereign immunity may be
waived with regard to debtor assets abroad, it is not waived with regard to domestic
policy, legislation, and enforcement. Sovereign immunity protects a debtor government’s power to tax sources of income and wealth within national borders. The
enforcement of private contracts between parties subject to different national
jurisdictions also requires the enlightened self-interest of sovereign governments.
Sovereign immunity is used as a fundamental assumption to derive intertemporalbudget constraints for sovereign nations and their governments. The capacity tofinance current aggregate consumption, investment, and government expendituresfrom global savings is determined endogenously given that a national government
acts only in the interest of its constituents while recognizing the consequences of
its actions for future transactions and international cooperation. Limits on public
debt and deficits are derived in a tax-smoothing model by finding an efficient global
equilibrium with international financial flows constrained by borrower sovereign
immunity and the willing participation of private creditors. The securities issued
by sovereigns are also endogenously determined; that is, the completeness or incompleteness of securities markets is determined in self-enforcing equilibria with andwithout restrictions on the information available to potential creditors.
Securities markets are incomplete in equilibrium. The model shows how contingent securities are required in international financial market equilibrium when
all information about the government is public. By contrast, when shocks to thegovernment’s objective are not publicly observed, contingent repayments are only
needed if outstanding government debt exceeds a threshold. A conclusion of thepaper is that conventional bonds that are renegotiated with positive probability only
as the government’s debt limit is approached support an efficient outcome withprivate information. In the full information case, payments on conventional bonds
would require renegotiation with positive probability every period for any debt level,

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

but in the incomplete information model, bonds are renegotiated only when thedebt limit is reached. This is consistent with the observation that renegotiations ofemerging market debt denominated in foreign currency are infrequent and happen athigh debt levels.
A major consideration of this paper is how constraints on government borrowing
may impact monetary policymaking. Efficiency requires that public debt repayments
be state contingent in a stochastic environment. A line of research beginning with
Lucas and Stokey (1983) studies the role of nominal public debt for achieving
state-contingent payments with endogenous or exogenous monetary policy.1 While
several papers (Lucas and Stokey [1983] and Persson and Svensson [1984] in particular) emphasize how denominating public debt in domestic currency creates an
inflationary bias for monetary policy, other papers (notably, Bohn [1988, 1990] andBarro [1999, 2003]) emphasize how nominal public debt can increase welfare
when the government is restricted to issuing non-contingent (conventional) bonds.2
With stochastic expenditures in a simple tax-smoothing model, payments to government
liabilities need to be contingent on expenditures in every period in the Lucas andStokey, and Bohn and Barro models. This suggests the conflict between state contingency and incentives for monetary policy brought out by Lucas and Stokey (1983).
This paper reconsiders the question of nominal debt versus real indexed debt (orforeign currency denominated debt) in the optimal contracting approach with thedebt limits derived endogenously from sovereign immunity. A main implication of
the literature cited above is that nominal government bonds implement an implicit
state-contingent (long-term) contract. Implicit contracts require self-enforcement,
and the equilibria discussed below are self-enforcing so that they are time consistent.
The introduction of incomplete information in the model implies that unanticipatedinflation with nominal debt contracts is only desirable if outstanding debt exceeds a
critical threshold. Also, in the optimum, inflation at most eliminates net real interest
on nominal bonds.
The two contrasting equilibria bring out constraints on both fiscal and monetary
policy. With complete information, government bond borrowing imposes a burden
on monetary policy to generate contingent inflation regularly. With private information, unanticipated inflation is required for efficiency with nominal government
debt only near the debt limit with adverse shocks. Otherwise, self-enforcing equilibria with nominal public debt work in favor of commitment in monetary policy,
particularly to predictable inflation, consistent with much of the recent literature on
monetary policy rules.
The renegotiation of foreign currency denominated debt issued by emerging
market debtors has been a protracted and costly experience over the years. By issuingbonds denominated in domestic currency, renegotiation can be easily implemented
1. For example, Persson and Svensson (1984), Bohn (1988, 1990), Calvo and Guidotti (1990), Giavazzi and Pagano(1990), Chari, Christiano, and Kehoe (1994), Missale and Blanchard (1994), Aiyagari et al. (2002), and Barro(1999, 2003).
2. Bohn (1988, 1990) considers why nominal public debt is predominant in light of the conclusions of Lucas andStokey (1983) and shows that nominal debt indexation is constrained optimal in a model following Barro (1979).
Barro (1999, 2003) argues that nominal indexation allows potentially welfare-improving contingent repayment
with exogenous stochastic inflation.

167

by the debtor, but this requires that national authorities face other costs of generating
unanticipated inflation that provide incentives for monetary restraint (to solve thetime consistency problem studied by Lucas and Stokey [1983], among many others).
For example, the holding of domestic currency debt by constituents can provide a
disincentive for the government to inflate. The ease of reducing repayments on
domestic currency debt ex post also implies that governments which cannot issue
such debt for reputational reasons may hold stocks of foreign nominal public debt inreserve for smoothing aggregate output and consumption. Reserve currency assets
provide an instrument for accumulating and decumulating public credit as necessary.
However, accumulating and expending reserves is not sufficient to implement anefficient outcome. In equilibrium, a reserve-accumulating country should switch toissuing liabilities subject to default and renegotiation when the lower bound on
reserves is reached.
The model of public finance in an open economy under sovereign immunity
with complete information is presented first. The model is then extended toallow incomplete information between the government and creditors that motivates
the role of conventional non-contingent bonds. The analysis is used to draw implications for constraints on macroeconomic policy, current account sustainability,
and the accumulation of reserve assets. The consequences of the derived debt
limits for interest rates and relative prices in a decentralized private economy arebriefly discussed.

II. Sovereignty and Public Debt in the Open Economy
A model of international financial transactions is analyzed in which national governments enjoy sovereign immunity. Sovereign immunity means that national authorities
can regulate activities within their jurisdiction through legislation, administration, andjudicial enforcement. Foreign governments cannot interfere with economic activities
within sovereign boundaries and cannot enforce contractual relationships without
the cooperation of national authorities. The enforcement of contracts between thedomestic private sector and foreigners within a country depends on the institutional
and legal solution chosen by a sovereign government. Sophisticated legal systems
may readily enforce contractual obligations of resident debtors on behalf of foreign
creditors without being subject to the whims of current authorities. However, suchinstitutions for domestic contract enforcement and the extension of its benefits toforeigners are chosen for the national benefit given incentives of international trade.
More specifically, a sovereign government chooses whether to honor its own
obligations, whether to foreign or domestic creditors. The ability of a sovereign toborrow depends upon its willingness to repay. Following the literature on sovereigndebt, fiscal authorities choose to repay if doing so is in the national interest,
anticipating the consequences of failing to fulfill contractual obligations in equilibrium.3
3. Models of sovereign debt based on willingness to pay begin with Eaton and Gersovitz (1981). A still timely andthorough review of country risk is given by Eaton, Gersovitz, and Stiglitz (1986).

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

The model presented focuses on the financing of public-sector budget deficits in an
integrated international financial market. The focus on public finance is natural,
because it is important in international finance and because it encompasses all
securities issued publicly or privately that enjoy explicit or implicit government
guarantees. Implicit guarantees, in the view of this paper, include the enforcementof private contracts and the protection of domestic debtors by the sovereign’s own
legal system.
The analysis uses a simple model of a fiscal authority seeking to smooth distortionary taxes over time against random shocks to domestic demand, following Barro(1979). The shocks in the model are stochastic exogenous government expenditures for
expositional convenience. These represent preference shocks reflected in the objectivefunction of the sovereign policymaker but can be interpreted as any exogenous shocks
to domestic absorption. In the model, fiscal authorities raise tax revenues to maketransfers from the domestic private sector to creditors, domestic and foreign. Moregenerally, taxation represents the capacity and willingness of the sovereign to ensure
private and public debt repayments. Sovereign borrowing should be interpreted
liberally as the issuing of any debt securities that can be held by foreign creditors byany debtor potentially protected by the sovereign.
The model allows for the integration of domestic financial markets withinternational financial markets. Private parties may be able to accumulate or
issue internationally tradable debt or perfect substitutes. Government debt may
be held by either domestic or foreign residents, allowing the sovereign to default
on its contractual obligations to either or both. Implicitly, bonds are heldanonymously so that the government cannot selectively default based on the debt
holder’s identity.

III. Deficit Finance and Foreign Borrowing
In a simple tax-smoothing model, government obligations are met by imposing
distortionary taxes. Tax distortions are captured simply by assuming that output is adecreasing and concave function of tax revenues, Y (T ) > 0, Y ′(T ) ≤ 0, Y ′(0) = 0,––––
and Y ′′(T ) ≤ 0 for 0 ≤ T ≤ T , where T > 0 is an upper bound on tax revenues.
Authorities seek to maximize the utility of a representative agent given by

Ut = u (ct ) + Et   s−tu(cs ),s =t +1(1)

with respect to the consumption plan, where ct = y (Tt ) = Y (Tt ) − Tt , given the needto finance exogenous government expenditures, g t . This simple model should beinterpreted as follows. Domestic residents seek to smooth their consumption overtime, but some households do not have access to internationally integrated financial
markets. A portion of domestic consumption cannot be smoothed by the private
sector, so the government smooths this consumption by issuing debt in the integrated
financial market. Both domestic and foreign savers can hold domestic government

169

debt. Government expenditures, g t , are independently and identically distributed
over a finite support. Substitution allows the government’s objective to be written as∼

Ut = v (Tt ) + Et   s−tv (Ts ),s =t +1

where v(T ) = u (Y (T ) − T ) displays negative and decreasing marginal utility in taxes.4
The trade balance is given byt = Y (Tt ) − ct − g t = Tt − g t .
The government issues securities on a global financial market to finance the primary
deficit, g t − Tt . The present value of all financial claims against the government isgiven by

wt = Tt − g t + Et   s−t (Ts − g s ).
s =t +1(2)

The government can issue new securities to finance current primary deficits or
the repayment of retiring debt. Debt holders can trade existing securities on theinternational financial market. The value of securities issued by the government canbe rewritten in the form
wt = −(g t − Tt ) + Et wt +1,(3)

where wt +1 is the value of outstanding debt conditional on the state in date t + 1.
Any individual creditor purchases government securities willingly in any period.
This assumption is expressed by the participation constraints,
wt ≥ 0 and wt +1 ≥ 0,
for all states and dates. That is, tradable securities can only have non-negative market
values. This rules out securities for which the expected present value can be negativein some future event, such as pure insurance contracts. The conditional expected
present value of current and future primary surpluses of the government is restricted
to be non-negative at all dates. The government can only force involuntary payments
to it by taxing economic activities within its sovereign domain. It can raise revenue
on an integrated financial market by issuing securities that always have non-negative
market values.
Another set of constraints is introduced to represent national sovereignty. Sovereignauthorities can elect to refuse to honor government-issued debt. The constraint that the
government will repay only if repaying is in the national interest at the time payments
are due is expressed by another participation constraint. The country can choose to
4. The replacement of a tax-smoothing objective for a consumption-smoothing objective for the representative
household is demonstrated in Zhu (1992).

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

adopt a pay-as-you-go basis for public finance by defaulting on its current debt andnever issuing debt again. The sovereignty constraint is expressed as

s =t +1

s =t +1

v (Tt ) + Et   s−tv (Ts ) ≥ v(g t ) + Et   s−tv (g s ),(4)

for all dates and states.
An equilibrium with symmetric information between potential creditors and theauthorities of the issuing government is characterized first. In equilibrium, securities
will have state-contingent payments. In the case of complete state-contingent markets,
only the single constraint,

w 0 = T0 − g 0 + E 0  t (Tt − g t ) ≥ 0,
t =1

(5)

would need to be imposed. With self-enforcing contracts, the constraint, wt ≥ 0,
needs to be imposed for all dates and states.
The equilibrium is found by maximizing

Vt = v (Tt ) − v(g t ) + Et   s−t (v(Ts ) − v (g s ))s =t +1= v(Tt ) − v(g t ) +  EtVt +1,(6)with respect to the current tax revenue, Tt , and future repayments, wt +1, for each stateof nature, subject to the constraints,
Tt − g t +  Et wt +1 ≥ wt ,(7)

wt +1 ≥ 0 and Vt +1 ≥ 0 for each state.

(8)

The surplus for the government, Vt , is a function of the outstanding value of its
debt, Vt (wt ).5
The solution for a self-enforcing equilibrium is familiar from Thomas andWorrall (1988), Kocherlakota (1996), Kletzer and Wright (2000), and Kehoe andPerri (2002). For this tax-smoothing model, the first-order condition for tax revenues
can be derived and is given byv ′(Tt ) = v ′(Tt +1) if wt +1 > 0 and Vt +1(wt +1) > 0,(9)v ′(Tt ) < v ′(Tt +1) < 0 if wt +1 = 0,

(10)

and
5. For the stochastic g t following a Markov chain (including independently and identically distributed g ), this surplus
can be written as V (wt , g t ). The model extends immediately to the case in which g t follows a Markov chain.

171v ′(Tt ) > v ′(Tt +1) < 0 if Vt +1(wt +1) = 0.

(11)

The solution for Tt +1 depends on g t +1 and wt (as does wt +1) and can be written as
Tt +1 =  ( g t , Tt ),since Tt conveys all information about wt .
In equilibrium, taxes are completely smoothed between dates if the participation
constraints for neither the government nor its creditors is binding (as in equation [9]).
Taxes rise with g t +1 if creditors’ participation constraints bind (as in inequality [10]),and fall as g t +1 declines if the government’s participation constraint binds as shownin equation (11). For independently and identically distributed g t , taxes and theprimary surplus are non-decreasing with government expenditures. These are also
increasing with the value of outstanding government obligations, wt .
The value of financial claims against the government is state contingent in thisequilibrium. As shown by Kletzer and Wright (2000) in a different context, this equilibrium can be implemented using single-period debt contracts with state-contingent
non-negative repayments. The amount borrowed by the government at any date t isgiven byl t = wt + g t − Tt ,the sum of outstanding public-sector liabilities at the beginning of period t andprimary deficit for period t. Repayments in period t + 1 are given by
R t +1 = wt +1.
An interpretation of the model is that equilibrium can be implemented throughcontinual renegotiation of standard debt contracts with fixed contractual repayments
equal to max {wt +1}. Renegotiation yields actual repayments equal to wt +1.6
The constraint on the government in the state-contingent economy differs fromthe conventional solvency constraint. By allowing for sovereign immunity, in thesense that foreign creditors can only indirectly influence the behavior of national
executive, legislative, and judicial authorities by not purchasing assets issued by thecountry, the country’s intertemporal budget constraint is given by
wt = − (g t − Tt ) +  Et wt +1 ≥ 0 and wt +1 ≥ 0,

(12)

and not by the conventional solvency constraint given bylim
Et  s−tbs+1 ≤ 0 for all t , where bs+1 = bs + ( g s − Ts ).
s →

(13)

6. This interpretation of debt renegotiation as the implementation of an implicit contract was suggested by Grossman
and van Huyck (1988).

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

The difference is that the conventional solvency constraint requires that the expectation of the present value of the primary surplus be at least as great as the current
outstanding debt at all dates,

wt = Tt − g t + Et   s−t (Ts − g s ) ≥ bt ,s =t +1(14)

while sovereign immunity imposes the weaker constraint on borrowing that wt begreater or equal to zero at every date.
The accumulation of credit to foreigners will be constrained by sovereign immunity
on the other side of the market. In this model, taxation captures the full capacity of
the government to ensure repayment on credit to borrowers subject to its jurisdiction.
This includes assets held by the public or private sector. Taxation is a catchall for thecapacity and willingness of the sovereign to enforce contractual and legal obligations
within its borders, including transfers between private parties ordered by the judicial
system to settle private contractual disputes. Government expenditures can be interpreted as both government purchases and transfer payments. The quantity, g t , can also
be interpreted as a stochastic share of aggregate domestic demand for tradable goods
that cannot be completely smoothed on international financial markets by households
and firms.
In equilibrium, the willingness of bondholders to purchase outstanding debt andaccept new debt issues constrains the capacity of the government to smooth thedistortionary cost of taxation. Incomplete smoothing arises because the sovereign only
services its debt if doing so is in its own best interest. With complete information,state-contingent repayments may be implemented through renegotiation where renegotiation is just the playing out of an implicit state-contingent contract. Asymmetric
information about the government’s willingness to repay debt can lead to incomplete
markets or costly renegotiation.

IV. Incomplete Information and Bond Lending
The complete information case implies that we should observe a rich set of statecontingent securities or very frequent international debt renegotiation. Asymmetric
information between debtors and creditors leads to an incomplete set of statecontingent securities. A simple assumption is that g t is observed by national
authorities but can never be observed by creditors. The variable, g t can be interpreted
as an unobserved taste shock in the government’s objective. One interpretation ofthis assumption is that national authorities are better informed of their capacity totransfer resources from the domestic private sector to creditors. Those who haveachieved political power in a country are likely to know more about the willingness
of residents to pay taxes for debt repayment than are individual bondholders or
foreign authorities.
The assumption that shocks to expenditures are only observed by the borrowing
government requires that equilibrium payments be incentive compatible for the173government.7 In an incentive-compatible equilibrium, the government will reveal
the correct realization of g t to creditors by its current choice of the primary deficit,
g t − Tt , which is observed by creditors. The separate components, g t and Tt , areprivate information. The gains from tax smoothing suggest that higher reported
expenditures should be associated with higher primary deficits. In the complete
information case, current repayments and new borrowing can be conditioned separately on the publicly observable state, g t . With incomplete information, incentive
compatibility requires that the government cannot pay less when g t is high without
repaying more in the future. Otherwise, the government could falsely report highexpenditures to lower the present value of its net repayments. In an incentivecompatible equilibrium, a favorable shock (lower g t ) should lead to a larger current
net repayment (a larger primary surplus) and lower future repayments.
Under private information, an equilibrium is found by maximizing the expectedvalue of government liabilities, Wt = Et −1wt , given a constraint set that includes the
incentive-compatibility condition for the government. The expected future surplus
for the government, EtVt +1, can be written as a function of the reported current state,denoted gˆt , and the value of future repayments to creditors, Wt +1. Current taxes should
also be a function of the reported state. The incentive-compatibility condition
requires authorities to be at least as well off reporting the actual state, g t , as reporting
any other state. It is written as
Vt ( g t , g t ) ≥ Vt (g t , gˆt ),(15)

for each state g t and all possible gˆt , where
Vt ( g t , gˆt ) ≡ v(Tt (gˆt )) − v(g t ) +  EtVt +1(gˆt ).8(16)

The properties of incentive-compatible equilibrium with commitment on one orboth sides of the market are well known (for the difficult one-sided commitmentcase, see Thomas and Worrall [1990]). While incentive-compatible solutions tend
to be complicated, allowing a continuous and bounded support for the shock g t
simplifies things greatly.9 Let the distribution of expenditure shocks have a continuous density over a fixed interval ([ g min, g max] where 0 < g min < g max). In the case offull commitment (no participation constraints), the incentive-compatible equilibrium is supported by conventional non-contingent bond contracts. The expected
present value of government liabilities,
Wt = Tt − g t + Wt +1,(17)

7. Atkeson (1991) introduces asymmetric information in a repeated moral hazard model of sovereign debt with
one-sided commitment. Kletzer (2005) considers bond contracts with no observability of debtor income in amodel with two-sided non-commitment.
8. The time subscripts on the functions reflects dependence on ex ante surplus, Et −1Vt .
9. The demonstration that standard debt contracts with bankruptcy are optimal incentive-compatible contracts isdue to Townsend (1979). In that model and others, debtor income is observable at a cost. Cole and Kocherlakota(2001) implicitly demonstrate bond contracting with no observability in a model with hidden savings and noself-enforcement constraints.

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

does not depend on the current shock, g t . This is the conventional budget identity
for bond borrowing. Since the discounted level of the future debt, Wt +1, varies one
for one with the primary surplus, the government has no incentive to misrepresent its
current state. The first-order condition for tax smoothing isv ′(Tt ) = Et v′(Tt +1).

(18)

The solution without participation constraints parallels equilibrium for self-insurance
in the permanent income model.10
The participation constraints for bondholders and for the sovereign remain
wt +1 ≥ 0 and Vt +1 ≥ 0,
respectively. If neither of these constraints binds in any possible state, g t +1, then thefirst-order condition (18) holds. If the government’s participation constraint binds
for some states, then the first-order condition becomesv ′(Tt ) ≤ Et v′(Tt +1) < 0.

(19)

In this case, the government’s primary surplus is constrained at time t in state g t by
its willingness to raise taxes to make repayments in some states at time t + 1. Whenthe participation constraints hold for the government’s creditors, the first-ordercondition is given byv ′(Tt ) ≥ Et v′(Tt +1).

(20)

In this case, the debt limit for the government is reached with positive probability.
The equilibrium when the sovereignty constraint for the government binds helps us
to understand the renegotiation of conventional debt contracts issued by sovereigns.
When participation constraints are not binding, equilibrium borrowing and repayment
are implemented by conventional non-contingent single-period debt contracts. Whenthe sovereignty constraint is binding with positive probability in the next period, thecontinuation surplus for the government, EtVt +1, equals its lowest possible value, whichis zero. Therefore, in any state g t thatv ′(Tt ) < Et v′(Tt +1),

(21)

the government’s continuation surplus must be zero. Otherwise, taxes could besmoothed more by reducing current taxes, Tt , and increasing the debt carried into thenext period (that is, lowering the continuation surplus, EtVt +1). The present value ofoutstanding debt is maximized when the government’s constraint binds. The debt
10. The model implicitly assumes no global constraints, and this first-order condition implies convergence toward a
steady state in which taxes are zero and the interest on government credit covers the upper bound for expenditures. With risk-averse counterparts, the steady-state gross interest rate, R, would be smaller than  −1 and thefirst-order condition would become v ′(Tt ) = R  Et v′(Tt +1).

175limit equals the expected surplus for creditors, Wt +1, when the expected surplus for the––government EtVt +1 equals zero. The debt limit is denoted W .11 Incentive compatibility
requires that the primary deficit be the same for any state such that inequality (21)holds. If this were not true, then the government could increase its primary deficit
without increasing its debt. Whenever the inequality (21) holds in a period, the value––of outstanding debt is W in the next period.
At the debt limit, taxes are a function of the current state and, naturally, at theirhighest level in equilibrium. Let Tˆ (g t ) be the maximum tax revenue collected in state
g t in equilibrium. At the debt limit, expected marginal utility, Et −1v′(Tˆ (g t )), is a constant if shocks are independently and identically distributed. In this case, there must
be a pivotal state, g–, such that inequality (21) holds for expenditure shocks greaterthan g–. In these states, the primary surplus will equal zero because the debt cannot
rise above the limit so that taxes equal expenditures, Tˆ (g t ) = g t , for g t ≥ g–. The pivotal
state is determined byv ′( g– ) = Ev ′(Tˆ (g t ))(22)

for g min < g– < g max. For expenditure states below g–, the government runs a primary
surplus and its debt falls (so that it has an incentive to run a primary surplus).
As the government’s debt rises to the debt limit, it follows the standard identity,

Wt +1 = Wt + (g t − Tt ),

(23)

until
v ′(g max) < Ev ′(Tˆ (g t ))(recall that g max is the largest shock to expenditures). For shocks such that the inequality(21) holds, the primary deficit can be positive but must satisfy––
W = Wt + (g t − Tt ).
In these circumstances, the primary deficit is independent of expenditures and current
taxes are given by––
Tt =Wt − W + g t .
–– ––Therefore, debt rises from Wt < W to W in period t + 1 if the shock at date t is equal
to or greater than gˆ (Wt ) which is determined by the condition––v ′(Wt − W + gˆ (Wt )) = Ev ′(Tˆ (g t )).

(24)

––
11. The debt limit W is determined endogenously by the condition,v (Tˆ (g t )) − v (g t ) +  EtVt +1 = 0,
and the inequality (21), which holds with equality for EtVt +1 > 0.

176 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

(F.1)

International Financial Integration, Sovereignty, and Constraints on Macroeconomic PoliciesAnother critical debt level, W, can be defined using the first-order condition as––
v ′(W − W + g max) = Ev′(Tˆ (g t )).

(25)

If the current debt, Wt , is less than W, then debt the next period, Wt +1, remains below
the debt limit with certainty. But if the current debt is above the critical level, W,
then the debt limit will be reached in one period with the probability that g t ≥ gˆ (Wt ).
––This probability rises with current outstanding debt in the interval, W ≤ Wt ≤ W , asgˆ (Wt ) decreases from g max to g– as Wt increases. For g t ≥ gˆ (Wt ), the primary deficit––
equals W − Wt . For g t < gˆ (Wt ), the primary deficit is decreasing in the expenditure
shock and must be in surplus for low expenditure shocks.

If the debt is below the critical level, W, public debt follows conventional debt
dynamics given and repayments are not state contingent. The ex post value of thedebt, wt , is the same as the ex ante expected value, Wt . The real rate of interest on
single-period bonds is equal to the riskless rate equal to the discount rate,  = (1 –  )/.
When the debt level is exceeds the critical level, the present value of outstanding
bonds varies with the expenditure shock. The return to single-period bonds is risky.
Past the critical level, the present value of public debt satisfies
Wt = Et −1[(Tt − g t ) + Wt +1],

(26)

rather thanWt = (Tt − g t ) + Wt +1,
because where wt = (Tt − g t ) + Wt +1 is state dependent. The single-period budget
identity can be rewritten as
Wt +1 = (1 + rt +1)[Wt + (g t − Tt )],(27)

where rt +1 is the ex post yield, which is stochastic if debt exceeds the critical level andequal to  if debt is below the critical level. For example, if the debt limit has alreadybeen reached, the rate of return is zero for adverse shocks because––––––
W = (1 + rt +1)[W + (g t − Tt )] = (1 + rt +1)W for g t > g–.

(28)

For g t less than g–, the yield is positive and falls with higher expenditures. Combining
equations (26) and (27) leads to (Wt + Et −1 (g t − Tt )) = Wt Et −1 rt + Et −1 [rt +1( g t − Tt )],(29)

implying that the actual return exceeds the discount rate for low expenditure shocks.
The equilibrium under incomplete information is implemented by one-period
contracts that are only state contingent when the present value of outstanding
government obligations is above a threshold. It could be implemented using standard

177

one-period debt contracts if these can be costlessly renegotiated in some events.
Renegotiation needs to occur with positive probability only when the debt levelexceeds the critical level. Under short-term bonds subject to renegotiated repayments,
the interest premium on public debt rises above the discount rate after the debt
reaches the critical threshold. In the model, creditors are risk neutral or, equivalently,
renegotiation risk is uncorrelated with global market risk. Extending the model toallow for risk-averse creditors would yield a risk premium on short-maturity debt that
only turns positive when the critical level is attained.
The lowest single-period ex post net yield on bonds is zero. At the debt limit,
bondholders lose net interest with an adverse shock but not bond principal. This
contrasts with the complete information case in which the gross return to creditors iszero in the worst state when tax smoothing is incomplete.12 Renegotiation is also an
infrequent event in the bond lending case.

V. Debt Limits and the Government’s Budget Constraint
The debt limit derived for the tax-smoothing model under sovereign immunity is
not the same as the conventional debt limit imposed in most models of government
borrowing. In the model with private information, government securities have noncontingent repayments unless the sovereignty constraints may bind with positive
probability before maturity. A natural interpretation is that equilibrium borrowing
and lending follow an implicit contract guided by standard non-contingent debt instruments. Contingent repayments are made through renegotiation of the net interest on
conventional bonds issued at interest rates that include a positive risk premium only when
the debt exceeds the critical level. Alternatively, an explicit state-contingent contract
would specify contingent repayments only when the debt is above the same threshold.
Imposing a conventional solvency constraint on bond borrowing does not allow
constrained efficient equilibrium tax smoothing in the presence of sovereign immunity.
The conventional approach, for example as followed by Aiyagari (1994) and others, sets
an upper bound on outstanding public debt, bt , given bys–bt ≤ ––,(30)

where s– is the largest primary surplus sustainable in equilibrium in all possible statesand  is the discount rate. This ensures that non-contingent debt will be repaid in all
events. An equilibrium for the tax-smoothing model can be derived adding the restriction that only non-contingent securities can be issued by the borrower.13 Restricting
contracts to be non-contingent in all events reduces the set of securities that can beused in equilibrium for the tax-smoothing model under private information, since
it eliminates securities that were needed to implement an efficient solution. Doing
12. This is equivalent to the incomplete consumption-smoothing case in Thomas and Worrall (1988), Kocherlakota(1996), and Kletzer and Wright (2000).
13. Two papers that endogenize the debt limit but place exogenous constraints on contracts are Aiyagari (1995) andAiyagari et al. (2002).

178 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies––
so must lead to a lower debt limit than the limit, W, derived above and to lesssmoothing of taxes. Here, sovereign immunity is a fundamental and the set of
securities is endogenous. In the conventional model, the form of securities and contract
enforcement are taken as exogenous.

VI. Nominal Debt, Renegotiation, and Debt Limits
The suggestion by Bohn (1988), Barro (2003), and others that issuing public debt
in domestic currency units allows state-contingent real repayments on standard
bonds was made in the context of complete information models. In those models,non-contingent bond contracts do not implement the constrained optimum, but
non-contingent nominal bonds and unanticipated inflation can generate the required
state-contingent real payments to bondholders.14 In this model of tax smoothingwith incomplete information, nominal debt and unanticipated inflation can serve
the same purpose of allowing state-contingent real payments with standard noncontingent securities. An important difference is that state-contingent repayments
are only required in a constrained optimum in some events: those that lead tooutstanding public debt above the critical threshold. In complete information
models, such as Bohn (1988), unanticipated changes in the inflation rate need to be
frequent to implement the optimum. In this model, inflationary surprises should
only occur in periods of high outstanding debt and high expenditure shocks. Theseare events in which repayment difficulties forcing debt renegotiation would occur if
non-contingent bonds are issued in real terms.
The introduction of nominal debt requires adding money and one-period nominal
debt with fixed money interest to the model. Formally, real balances can be introduced
as an argument in the utility function for domestic residents in an additively separable
way. This gives a standard relationship between current consumption, the nominal
stock of money, the nominal interest rate, and the price level. For example, forlogarithmic utility in real balances, real balance demand will be given by
1 + i t +1–,
M t = u′(c ) ––––––––
ti t +1pt(31)

for a constant  and nominal interest rate i t +1. Outstanding nominal debt is given by
Bt = ptWt , so that nominal debt evolves according to
Bt +1 = (1 + i t +1)[Bt + pt (g t − Tt )],(32)

and real debt follows
pt
Wt +1 = –––p (1 + i t +1)[Wt + (g t − Tt )].
t +1

(33)

14. Barro (2003) does not model optimal fiscal and monetary policy with nominal debt, but instead argues that
nominal debt with independently determined inflation allows state contingency that may be welfare improving.
Bohn (1988, 1990) considers optimal policy without endogenizing debt limits.

179

If inflation is stochastic, then the change in the real value of the debt is also stochastic.
Replication of the equilibrium with sovereign bonds requires that the real return tonominal bonds equals the equilibrium yield for real bonds,
pt–––
pt +1 (1 + i t +1) = 1 + rt +1.

(34)

When the real value of the debt is less than the critical level, the Fisher interest parity
condition,
pte+1(1 + i t +1) = –––p – ,
tholds, where actual inflation must equal expected inflation to support the constrained
optimum with non-contingent nominal interest rate bonds. When the debt is above
the critical level, then actual inflation should deviate from expected inflation tosatisfy equation (34). State-contingent fluctuations in the ex post real yield on bonds
could be accomplished with unanticipated inflation brought about by surprise money
supply growth in this framework. This suggests that issuing debt denominated indomestic currency could allow the implementation of the constrained efficientequilibrium without explicit state-contingent government securities or debt
renegotiation when the debt exceeds the critical threshold. By contrast, bonds
indexed in commodity units or in terms of the currency of another country would
need to be renegotiated and restructured explicitly when the debt limit is reached,perhaps following outright default.
Achieving state contingency through unanticipated inflation with domestic
currency debt raises the problem of how to enforce an implicit contract. That is,what keeps the debtor from reducing the real value of its debt too much throughunanticipated inflation? In the complete information model of sovereign debt,
Kletzer and Wright (2000) demonstrate how equilibrium state-contingent loans canbe enforced by market participants. In their model, deviation from the implicit
contract constitutes default and results in a short-lived embargo on new real resource
inflows until the debtor makes a payment to its creditors that eliminates the gainfrom default.15 The proof that credit markets are sustainable without interferingwith sovereign immunity can be extended readily to the tax-smoothing modelwith asymmetric information. However, the case of nominal debt contracts withunanticipated inflation requires more interpretation.
Suppose that a sovereign with outstanding debt denominated in the sovereign’s
own currency increases the money supply by more than is mandated by equation(34). This reduces the real value of the outstanding stock of debt, deviating from theequilibrium expected by bondholders. The punishment needed must lower the
debtor’s continuation surplus, EtVt +1, to at least offset the increase in the debtor’scurrent gain from generating too much inflation. This can be accomplished byissuing new nominally indexed debt or issuing new debt that is real indexed or in
15. Kletzer and Wright (2000) prove that a coalition-proof equilibrium exists. Wright (2001) proves that the result
carries over when creditors can commit but are oligopolistic for a less strict definition of coalition-proofness.

180 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

another currency. In the first case, the existing debt may be refinanced by issuing new
bonds denominated in the debtor’s currency at nominal interest rates exceeding therequired equilibrium real rate of return by an inflation rate that is a credible upperbound for the sovereign’s currency. That is, excessive money supply growth at timet – 1 results in inflation, pt′/pt −1, reducing the value of nominal debt claims to Wt ′from what was expected, Wt ,pt −1
Wt > Wt ′ = –––– (1 + i t )[Wt −1 + (g t −1 − Tt −1)].
pt′

(35)

The terms of the new issues, including the primary surplus at time t, would need tosatisfypt′
Wt +1 ≤ –––– (1 + i t′′+1)[Wt ′ − s t′′ ],
pt′+1

(36)

where primes denote the deviation from the equilibrium and double primes themarket response. This response ensures no gain from deviation. This notion hinges
on the credibility of an upper bound on the inflation rate for the sovereign issuer.
If the government suffers other losses from higher inflation (as in many models ofmonetary policy), then a credible bound on inflation is possible.16 If the government
is not inflation averse, then reversion to foreign currency bonds remains a punishment strategy. It may be the case that the government does not take account of
the welfare of its domestic creditors or that foreign bondholders do not know thegovernment’s objectives (there are additional asymmetries of information). New debt
accomplishes the same purpose as condition (36) by satisfying the constraint
Wt +1 ≤ (1 + r t′′+1)[Wt ′ − s t′′ ],(37)

where the real interest rate and primary surplus leave the borrower with no gain fordevaluing the outstanding debt the previous period.17

VII. Implications for Foreign Borrowing and Reserves
Financial assets traded across borders are subject to sovereign risk whether issued by
the government or by domestic private debtors. The tax-smoothing model can beinterpreted as a model of international borrowing by reinterpreting the primary
deficit as the trade balance and outstanding debt as the net foreign liabilities of theeconomy. The current account balance measured in tradable goods is given by
16. A natural explanation of how a currency becomes a reserve currency is that a large share of government debt isheld by constituents of the issuing government. An early version of such a model is Buiter and Eaton (1985).
17. As in deviations from equilibrium payment with contingent contracts and sovereign risk, holders of debt at time t − 1
do suffer capital losses. The borrower cannot gain by deviating from the implicit contract in perfect equilibrium(see Kletzer and Wright [2000]).

181

Wt +1 − Wt = rt (Wt + g t − Tt ).

(38)

The conventional solvency constraint is again inconsistent with a constrained
optimum with internationally integrated financial markets. In equilibrium with private
information, repayments only need to be state contingent once the debt exceeds thecritical threshold. When external debt is above the critical level, payments on nominal
non-contingent bonds can be reduced through surprise inflation, but payments on
foreign currency denominated bonds must be renegotiated to achieve the required statecontingency. For the case of foreign currency denominated debt, debt renegotiation canbe protracted and costly. Any such additional costs would need to be acknowledged
when interpreting the sovereignty constraint.18
The capacity to issue debt denominated in the sovereign’s currency creates a natural
way to implement state-contingent repayments, but relies on the costs of unanticipatedinflation to the sovereign’s own objectives. This implies that internationally traded debt
will be denominated in the currencies of nations whose governments face high domestic
costs of inflating away the value of outstanding nominally indexed public debt.
International reserve assets denominated in foreign currencies can play a role ininterpreting equilibrium in the sovereign borrowing model. Interest-bearing assets
issued by the reserve currency country can be accumulated by a government thatcannot issue debt in its own currency through capital inflows generated either by acurrent account surplus or foreign investment. These assets can be used to financefuture current account deficits.
In the model, only changes in the net debt or credit of the government are determined. Whether the country is a net issuer of bonds or holder of the debt of othersovereigns is indeterminate. The model can be used to consider a government thatsmooths taxes against stochastic domestic shocks by accumulating and decumulatinginternational assets denominated in a reserve currency. The reserve-accumulating
government can solve the problem of maximizing its surplus with respect to current
taxes and future reserves,
Vt (a t ) = max {v(Tt ) − v (g t ) +  EtVt +1(a t +1)},(39)

where reserve assets, a, follow the conventional identity

 at +1 = at + (Tt − g t ).

(40)

This is a storage problem with possible stock outs when reserves reach zero withpositive probability in the next period. The first-order condition is still given byinequality (19),v ′(Tt ) ≤ Et v′(Tt +1).

18. An explicit model of protracted and costly debt restructurings based on models of debt renegotiation is given by
Kletzer (2003).

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

When reserves are sufficiently low, these go to zero (or an arbitrary lower bound) inhigh-expenditure states. In low-expenditure states, the government smooths taxes byaccumulating more reserves becausev ′(Tt ) = Et v′(Tt +1),
in favorable states. However, positive savings in non-contingent bonds yields a positive
surplus,v (Tt ) − v(g t ) +  EtVt +1(a t +1) > 0,
when a t = 0 and a t +1 =  −1(Tt − g t ) in these states.
To achieve the constrained optimum, more surplus needs to be extracted when
government credit goes to zero. The government must also borrow in addition tosaving through the accumulation of reserve assets to efficiently smooth taxes undersovereign immunity. Therefore, a government that cannot sell securities denominatedin its own currency internationally should issue foreign currency (or real-indexed)
liabilities. These liabilities will be subject to renegotiation in a constrained efficientequilibrium.

VIII. Decentralized Equilibrium and the Current AccountApproaching the debt limit, the trade deficit must eventually decrease and turn tosurplus. In a decentralized economy, this is achieved by movements in real interest
rates and the relative prices of goods and services. Marginal utility, v′(T ), can beinterpreted as the marginal utility of repaying an amount T by a representative
household (so that u′(ct ) = −v′(Tt )). For a sufficiently adverse shock with net external
debt above the critical level, the first-order condition is given byu ′(ct ) ≥ Et u′(ct +1).

(41)

The domestic real interest rate for the decentralized economy, rt +1, is determined byu ′(ct ) =  (1 + rt +1)Et u ′(ct +1).

(42)

The real interest rate rises above the discount rate as external debt passes the criticallevel. The increase in the interest rate induces a rise in domestic saving that reverses
the trade balance and current account when the debt limit is reached.
With tradable and non-tradable goods, the real exchange rate will also respond as
debt passes the critical level for an endowment economy. The contraction in tradable
goods consumption will be determined by the first-order conditions,u 1′(ctT, ctN ) ptT–––––––– = ––– ≡ qt ,u 2′(ctT, ctN ) ptN

(43)

183

and
u 1′(ctT, ctN ) =  (1 + rt +1)Et u 1′(ctT+1, ctN+1),(44)

and the equilibrium conditions,
ctN = y tN, ctN+1 = y tN+1, and Wt = ctT − y Tt + Wt +1,(45)

where the real interest rate, rt +1, and net foreign assets, Wt , are in terms of tradable
goods. Real exchange and interest rate changes will depend on the elasticities ofsubstitution between goods and over time.

IX. Conclusion
The capacity of sovereigns to choose whether to honor public debts or enforce private
debts inhibits the ability of foreign creditors to enforce contractual obligations in international finance. It also restricts the access that countries have to international financial markets, constraining the scope for national policymaking. Restrictions on sovereign borrowing naturally lead to constraints on net external asset positions and current
account dynamics, as well as public-sector budget deficits and debt. The model of sovereign borrowing adopted here stresses the endogeneity of borrowing limits tothe objectives of national governments and domestic and foreign fundamentals.
The analysis shows that conventional debt limits based on certain payment of bonds
may not lead to the equilibrium intertemporal constraints on national policymakers.
Endogenous constraints derived under information asymmetries that motivate
conventional bond contracts require that the repayment on sovereign bonds become
state contingent as debt limits are approached. Renegotiation of the terms of repayment is necessary if bonds are issued with non-contingent repayments in real terms.
If bonds are issued with non-contingent repayments in terms of the issuer’s own
currency, then inflationary capital losses for bondholders are consistent with theconstrained efficiency of equilibrium.
The usefulness of nominal public debt for achieving contingent repayments with atax-smoothing motive under uncertainty is reconsidered by comparing equilibriumwith and without private information for the debtor. In the complete information case(corresponding to previous models, for example, Bohn [1988] and Barro [2003], withconventional solvency constraints), optimal inflation is stochastic each period. This
conflicts with the commitment in monetary policymaking needed to resolve timeconsistency problems. The incomplete information model implies that debt reduction
through unanticipated inflation should not be an everyday contingency. Debt
reduction should be restricted to times in which outstanding debt exceeds a criticalthreshold and to holding the debt to the debt limit. Therefore, the denomination of
public debt in domestic currency does not necessarily conflict with time-consistentmonetary policy. Indeed, inflation targeting is not in conflict with optimal nominal
debt when debt constraints are not binding. High debt does constrain monetary

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International Financial Integration, Sovereignty, and Constraints on Macroeconomic Policies

policy by providing incentives to deliver unanticipated inflation, but credibility infiscal policy (the reputational equilibrium is supportable by credible punishments)
limits the erosion of the real value of debt during a crisis.
The convenience of one-sided renegotiation of the real terms of repayment with
monetary expansion will be an option for governments that are sufficiently averse
to unanticipated inflation. Inflation aversion can be associated with government
objectives that weight the welfare of domestic holders of nominal debt (including noninterest-bearing money). Governments lacking credibility for inflationary restraint or
fiscal discipline may not be able to issue debt denominated in domestic currency. With
complete information, contingent repayment is needed in all periods in the optimum
implying frequent, indeed constant, renegotiation. With incomplete information, debt
renegotiation is required only when the debt limit is reached. This corresponds toempirical experience. Debt restructurings are infrequent, the debt to GDP ratio is astrong predictor of default and renegotiation, and overwhelmingly emerging market
public debt is issued as foreign currency non-contingent bonds or loans.
Constraints on monetary and fiscal policy derive from the need to enforce reputational equilibria consequent to issuing debt denominated in national currency units on
an open market in the framework of this paper. Monetary expansions and contractions
will be constrained by the level of outstanding nominal debt in the extension to a
reputational equilibrium in both monetary and fiscal policy. The role of seigniorage
revenue was not included, because no new issues arise from sovereign immunity.
The constraints on fiscal policies, and, more generally, current account balances, areindependent of monetary policy in the model because full price flexibility was assumed.
However, introducing a role for monetary policy through nominal price rigidity andimperfect competition will not change the implications if creditors have symmetricknowledge of the objectives of national policymakers and the fundamentals that
motivate monetary expansion.

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Comment

Comment
JEROMIN ZETTELMEYER19
International Monetary FundThis is a very good paper that rigorously explores some of the joint implications offinancial integration and limited enforcement of cross-border borrowing contracts.
My comment makes two points. First, although there is nothing in the paper thatmakes it specifically a model of emerging markets, the model seems to describe thebehavior of emerging market economies better than that of advanced economies, forwhich the policy constraints derived in the model do not generally appear to bind.
That in itself is interesting, as it raises the question of why advanced economies aredifferent. Second, as an exploration of the costs, benefits, and effects of financial
integration on emerging market countries, the model is quite restrictive, looking only
at a subset of the issues. Hence, paradoxically, although the model evokes problems
that one associates mainly with emerging market countries, it takes a narrow viewof the costs and benefits of financial integration that seems justifiable mainly foradvanced economies.
Before elaborating on these ideas, it is useful to summarize the model’s main
predictions. In essence, the paper argues that financial integration—open capital
accounts—can place tight constraints on both fiscal and monetary policies (evenunder a floating exchange rate regime). Fiscal policy is constrained because deficits
can only be financed within limits. For sufficiently high debt levels, taxes will haveto be raised in response to domestic shocks—represented in the model as shocks togovernment spending—and eventually repayments may have to be renegotiated.
Monetary policy is constrained, because in the presence of nominal debt inflation
determines the real value of debt service; hence, an unexpected increase in inflation
amounts to implicit default, with repercussions for future lending. What generates
these constraints is the combination of three assumptions: financial openness, which
implies that the government can tap savings (domestic or foreign) only if it offers
an appropriate return; sovereignty, which puts a limit on the total amount that acountry can borrow without being tempted to default; and incomplete information
about country fundamentals, which implies that investors do not know whether
failure to repay in full can be justified by a bad shock or whether it indicates anattempt to repudiate debt.
To these implications, one might add a third one, which is not worked out in themodel but follows from the same logic: procyclical fiscal policy. Imagine that output
is stochastic, and that taxes depend on output. When the economy is in a creditconstrained state, as may occur if past shocks have led to a high level of debt, anegative output shock cannot be smoothed by allowing the deficit to rise; it must be
offset through higher tax rates or lower spending. More sophisticated versions of this
19. I thank Kenneth Kletzer and Olivier Jeanne for discussions on the subject. The views expressed in this comment
are those of the author and do not necessarily represent those of the International Monetary Fund (IMF) or
IMF policy.

187argument are possible; in particular, fiscal policy could become procyclical even when
the government is not yet credit constrained, but its debt is viewed as risky, since
governments may want to avoid burdening themselves with additional expensive debt
(Guerson [2003]).
These implications ring true for emerging market economies, where procyclicalfiscal policy is the norm (Gavin et al. [1996] and Talvi and Vegh [2000]), debt
restructurings are frequent, and lack of inflation credibility is often a barrier toissuing local currency debt. But advanced economies seem to act differently: they
have not defaulted since the 1930s, they engage in countercyclical fiscal policy, andthey generally behave as if they were not credit constrained. As far as monetary policy
goes, the model offers an interesting interpretation of why countries may seek toavoid inflation spikes, namely, to avoid rattling the debt markets. However, avoiding
inflation spikes is also consistent with the declared objective of monetary policy invirtually all advanced countries, namely, to stabilize inflation at low levels, which may
be optimal for reasons quite unrelated to international borrowing. Hence, it seems
unlikely that reputational concerns in credit markets impose a binding constraint onmonetary policy in these countries, in the sense that policymakers may be forced torefrain from actions that they would otherwise like to take.
Hence, the model appears useful mainly as an exploration of macroeconomic
constraints faced by financially integrated developing countries. For this class ofcountries, however, we may want to consider a somewhat broader range of costs andbenefits of financial integration than is emphasized in the paper. Consider first thepotential costs. A superficial reading of the paper might give the impression that thecosts of integration are the tighter constraints imposed by globalization on macroeconomic policy—in other words, a loss of control or flexibility. However, this is not
the case, at least not in a welfare sense, as there are no welfare costs of integration in
the model. The only potential cost associated with open capital accounts is the needto periodically renegotiate one’s debt; however, renegotiation is assumed to beefficient. Granted, in a state of financial autarky, macroeconomic policies might
appear to be less constrained: monetary policymakers will not have to worry aboutrepercussions in credit markets, and fiscal policy could perhaps tap domestic savings
more easily. But none of these policy actions would serve to improve welfare, since inthe paper’s model any welfare benefits of macroeconomic policies operate via
improved risk sharing with the outside world. Fiscal policy, for example, is useful
only as a channel for allowing external borrowing, from which some households are
excluded by assumption. Government borrowing from domestic households plays norole, since the only objective of fiscal policy is to smooth the consumption of justthose households.
Hence, there is no sense in this paper that emerging markets could make themselves worse off by integrating financially. Note that this is likely to remain true even
if the paper is extended in some ways that might be natural based on the current
model, for example, by introducing explicit costs to renegotiations. Even with costly
renegotiation, financial integration allows some risk sharing while autarky does not;hence, integration remains desirable (though it might lead to less foreign borrowing
and, hence, less risk sharing, compared with the case in which renegotiations are

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not costly). And even if monetary policy is given an explicit output-smoothing rolein the model, so that a constraint on the conduct of monetary policy might be a real
disadvantage, it is not clear from the model that financial integration would, in fact,
constrain the monetary authorities in their output-smoothing role. The monetary
authorities may not have to resort to inflation surprises to smooth business cycles.
The potential benefits of integration are also defined fairly narrowly. The only
benefit considered is consumption smoothing via foreign borrowing. But based on
calibrated models, this benefit—which could be regarded as the counterpart of
the welfare losses arising from output fluctuations at the business-cycle frequency,
though it is not modeled in this way in the paper—does not appear to be verylarge. Sovereign debt models relying on this channel alone imply debt ceilings ofat least one order of magnitude below the debt levels that are observed in real life.
For example, Arellano and Heathcote (2003) argue that if exclusion from futureborrowing were the only channel through which defaulters could be sanctioned,
countries could sustain debt levels on the order of only 1–3 percent of their GDP.
As the paper acknowledges in its introduction, a broader view of the possible
implications of financial integration for emerging market countries would consider
both bigger potential costs and larger potential benefits. On the cost side, the mostobvious candidate, familiar from the debate following the Mexican and Asian crises,
is that financial market integration exposes developing countries to sudden capitalflow reversals that can lead to sharp and painful drops in output. Two ideas playa role here. First, international capital markets can be fickle; they may shut out
emerging market borrowers precisely when they are needed most. Compared withthe advanced countries, emerging market access to international capital is unstable,
for reasons that may have to do with a deep lack of institutional credibility(Rajan [2004]). Second, international capital markets may occasionally be a sourceof problems, exposing countries to new types of shocks—shocks to international
interest rates or risk preferences, and contagion from other emerging market crises.
In light of balance-sheet mismatches or other financial frictions, these can have verylarge adverse effects on emerging market economies, and self-fulfilling runs may
become possible (see Arellano and Mendoza [2002] and Jeanne and Zettelmeyer[2004] for recent surveys).
On the benefits side, two potential benefits of financial integration (in addition torisk sharing) have been discussed in the literature. One is the old argument that,with open capital accounts, capital can flow to where it is needed most—that is, tocountries where there is relative capital scarcity. But when examined more closely,
the potential welfare gains associated with this type of convergence appear small(Gourinchas and Jeanne [2004]). The intuition behind this result is that, in aneoclassical growth framework, all that financial integration does is enable a fastertransition to a country’s long-term growth path. Without financial integration, if thelong-run path of GDP remains the same, convergence just takes longer as capital
accumulation needs to be financed through domestic savings. To have truly large
welfare effects, financial integration would need to have an impact on steady-state
productivity rather than just the speed of transition. Some recent papers havediscussed the possibility of such an effect, focusing on the potential link between

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open capital accounts and better government policies (Tornell and Velasco [1992]
and Gourinchas and Jeanne [2002]). The empirical evidence on this link is mixed sofar (Tytell and Wei [2004]).
To conclude, financial integration does seem to impose strong constraints on
macro policies in emerging market economies—both in ways suggested by theauthor’s paper, and beyond. In contrast, for advanced economies, these constraints
generally do not appear to be binding. As pointed out by Kearns (2005), one
explanation for this difference could be the more volatile economic environment inemerging market countries, which would lead to lower debt limits. Another reason,outside the paper’s model, could be better institutions and, hence, higher credibility
for a country’s efforts to adjust to shocks without going into crisis. Finally, the costs
and benefits of financial integration for emerging market economies are much more
complex than modeled in the paper, and whether the benefits outweigh the costs isstill a matter of debate. However, to the extent that financial integration is partly
endogenous to trade integration and economic development, the real policy issue
may not be making a clean choice between financial autarky and integration, butrather whether financial integration should be resisted at the possible expense of new
costs or distortions.

References

Arellano, Cristina, and Jonathan Heathcote, “Dollarization and Financial Integration,” mimeo, Universityof Minnesota and Georgetown University, 2003.
———, and Enrique G. Mendoza, “Credit Frictions and ‘Sudden Stops’ in Small Open Economies: An
Equilibrium Business Cycle Framework for Emerging Markets Crises,” NBER Working Paper
No. 8880, National Bureau of Economic Research, 2002.
Gavin, Michel, Ricardo Haussmann, Roberto Perotti, and Ernesto Talvi, “Managing Fiscal Policy in
Latin America,” IADB Working Paper No. 325, Inter-American Development Bank, 1996.
Gourinchas, Pierre-Olivier, and Olivier Jeanne, “On the Benefits of Capital Account Liberalization for
Emerging Economics,” mimeo, University of California, Berkeley, 2002.
———, “The Elusive Gains from International Financial Integration,” IMF Working Paper No. 04/74,
International Monetary Fund, 2004.
Guerson, Alejandro, “On the Optimality of Procyclical Fiscal Policy When Governments Are Not
Credible,” unpublished Ph.D. thesis, George Washington University, 2003.
Jeanne, Olivier, and Jeromin Zettelmeyer, “‘Original Sin,’ Balance Sheet Crises and the Roles ofInternational Lending,” in Barry Eichengreen and Ricardo Hausman, eds. Other People’s Money:
Debt Denomination and Financial Instability in Emerging Market Economies, Chicago: Universityof Chicago Press, 2004 (also available as IMF Working Paper No. 02/234, International Monetary
Fund, 2002).
Kearns, Jonathan, “Comment on ‘International Financial Integration, Sovereignty, and Constraints on
Macroeconomic Policies,’” Monetary and Economic Studies, 23 (S-1), Institute for Monetaryand Economic Studies, Bank of Japan, 2005, pp. 191–194 (this issue).
Rajan, Raghuram, “Dollar Shortages and Crises,” NBER Working Paper No. 10845, National Bureau
of Economic Research, 2004.
Talvi, Ernesto, and Carlos Vegh, “Tax Base Variability and Procyclical Fiscal Policy,” NBER Working
Paper No. 7499, National Bureau of Economic Research, 2000.
Tornell, Aaron, and Andrés Velasco, “The Tragedy of the Commons and Economic Growth: Why Does
Capital Flow from Poor to Rich Countries?” Journal of Political Economy, 100 (6), 1992,
pp. 1208–1231.

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Comment

Tytell, Irina, and Shang-Jin Wei, “Does Financial Globalization Induce Better Macroeconomic
Policies?” IMF Working Paper No. 04/84, International Monetary Fund, 2004.

Comment
JONATHAN KEARNS
Reserve Bank of Australia
The paper presents an elegant model that is both parsimonious and transparent.
It provides a useful framework for examining the debt levels that countries can carryin a model in which sovereigns can default and taxes are smoothed intertemporally.
By considering only that part of consumption that cannot be smoothed directly by
consumers, the model transforms a familiar consumption-smoothing problem into a
tax-smoothing problem. As someone who does not have a lot of experience in thisarea, I learned a lot from reading the paper. While the model is not empirical, andobviously must make many assumptions to be tractable, I personally find that it isuseful to consider theoretical models in the light of the real-world phenomena they
represent. My comments address the paper from this perspective.
The core of the paper is the derivation of debt thresholds when there is an
informational asymmetry. There are three regions for debt levels. Below the debtlevel W, there is no probability of default next period. The country can borrow as––much as it needs at the risk-free interest rate. In the next region, between W and W ,there is some probability that the shock next period will be so large that the government will not be able to repay. In this region, the country can still borrow, but at ahigher interest rate that incorporates a risk premium. A country in this region is at
risk of default, in part because the higher interest rate places greater demand on fiscal––
resources. The final region is given by W , the country’s maximum equilibrium debt
level. The country cannot borrow any more, and in bad states of the world cannot
make debt repayments.
As a first pass at relating the model to the real world, we can consider what typesof countries are in which regions. The model makes no assumptions about thecountry represented, and so can be applied to both developed and developing
countries. Indeed, the model can produce great diversity of default histories and risk
premiums, as witnessed in the real world. Developed countries logically fit in thefirst region. Their shocks are small enough relative to their debt threshold W thatthey can borrow with effectively no risk premium and do not default. Some emerging
market economies are also fortunate enough to be in this region. Other emerging
market economies are in the second region. They pay a risk premium and occasionallyhave debt restructuring or outright default.
But the fact that emerging markets are in the higher debt region does not necessarily mean that they have more debt. Debt thresholds can differ for each country.
Indeed, the paper notes that in generalizations of the model, the debt thresholds
would depend on domestic savings, investment, consumption, and production. One
feature of the model already lends itself to understanding different debt thresholds
for different countries. The more volatile is the exogenous shock (government191


expenditure), the lower will be W, the threshold at which debt becomes risky. While
there are obviously limits to interpreting this shock too literally, in many developing
economies it is clear that government revenue is more volatile (often because it is tied
to commodity prices and the revenue base is narrower), and that macroeconomic
shocks are larger and political uncertainty greater. Temporary illiquidity can also be
a big factor in sovereign defaults, and a surprisingly large shock, g, can easily beinterpreted in this way. Also, if the tax base is narrower in a developing country—sothat changes in the tax level are more distortionary and the output function Y (T )which depends on taxes is more concave—then this developing country will try
harder to smooth taxes. To do this, it needs to take on more debt in response to a––bad shock. All of these factors can widen the range (between W and W ) in which an
economy is at risk of default and so must pay a risk premium. They can then explain
why developing countries pay higher interest rates and default more frequently.
Another feature of the model that matches history is that those countries which
default are likely to do so repeatedly. A country that recovers from default, because
it experiences a sequence of small shocks, will still have debt near the top of thedefault-risk region and so will be living on the edge. A few bad shocks, and it can slip
back into the default region.
Seen in this light, the debt thresholds in the model draw a nice parallel to theempirical work on debt intolerance by Reinhart, Rogoff, and Savastano (2003).
These authors conclude that macroeconomic instability, a weak fiscal structure, andweak financial systems can lead to lower sustainable levels of debt. It is relatively easy
to relate these concepts to the determinants of the thresholds in the present paper.
Reinhart, Rogoff, and Savastano (2003) also find that countries with lower debt
tolerance have a history of default and high debt-to-GDP ratios. These two variables
are also key explanators of the likelihood of default in this paper. So on this front, themodel seems to mesh nicely with empirical work.
In some other respects, the model can also be related to the real world without
stretching the imagination too much. In the asymmetric information equilibrium,countries issue regular bonds rather than state-contingent bonds. While there are
seemingly many benefits to proposals for state-contingent lending (for example,
through bonds linked to GDP or commodity prices), in practice regular bonds arestill the norm. So perhaps the reality is, as the paper suggests, that regular bonds act
as implicit state-contingent debt. In this interpretation, it is common knowledge that
renegotiation or default will occur in bad states. But creditors accept this because of
the higher interest rates in good states.
In the paper, equilibrium is sustained without resorting to exogenous penalties
because lenders will withhold credit from defaulters until compensation is paid.
While the equilibrium is clearly dependent on this assumption, I do not take this tomean that the main conclusions of the model would be overturned if other explanations of sovereign repayment (such as trade or credit sanctions, reputation outside
credit markets, or legal sanctions) turned out to be more relevant empirically. What is
important is that sovereigns have some incentive to repay their debts. Intuitively atleast, the implications for debt levels would remain.

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However, there are limits to interpreting the model as an explanation of countries’
actual experiences with default, and I think some of these come through in theapplications considered in the paper. In the model, lending is countercyclical, andcountries borrow more when they experience a bad shock, at least up until they are attheir debt limit. In practice, at least for emerging markets, the procyclicality of capital
flows is well established and a challenge for macroeconomic management. The factthat capital flows typically dry up when a country needs them most presumably
increases their risk of default.
Another limitation comes through in the dynamics of the game. While the model
has an infinite horizon, I see it more as a one-shot game, as it does not incorporate
the dynamics that seem important in practice. There are no costs of defaulting(other than the need to compensate creditors for their forgone interest). But inthe real world, the debtor faces substantial costs of default, including lost output
and investment, and the potential weakening of the financial system and politicalinstitutions. The costs to the creditor of default are also substantial with write-downs
in excess of 50 percent not uncommon, at least in the recent past. The nature ofthese costs is likely to greatly change the dynamics of the system. Countries that havenever defaulted will attempt to maintain that record at great domestic cost. For
example, during the 1930s Great Depression, Australia’s debt-to-GDP ratio peaked at
200 percent and interest payments at around 30 percent of export revenue. Despite
the dire economic situation, the government implemented harsh policy measures,
including tax increases and a 20 percent reduction in expenditures, because the
top priority of economic policy was avoiding default on foreign debt. The long-run
benefits of these actions are quite clear, with this commitment contributing toAustralia now being able to borrow abroad in Australian dollars, a topic I have
explored in work with Ricardo Caballero and Kevin Cowan (Caballero, Cowan, andKearns [2004]). Another factor complicating dynamics in the real world is that many
developing countries issue debt with a much longer horizon than the length of crisis
episodes, which we might consider as one period in the model.20 So the real world
does not reduce to a repeated game, but has greater continuity.
The paper ties debt and default to monetary policy by suggesting that inflating
away debt in bad states is one way that countries can turn their regular bonds into
implicit state-contingent loans. Yet in practice, few countries are able to issue debt
abroad in their own currency, and those that can seem to be at very little risk ofdefault. This mechanism is more relevant for domestic debt, but even here it seems to
be limited, since countries that have a history of default often have much of theirdomestic debt indexed, for example, to short-term interest rates or inflation.
Alternatively, when countries are able to borrow domestically in their own currency,
the debt has such a short horizon that the ability of the government to reduce its realvalue through inflation is limited and interest rates are high enough to compensate

20. Given the repeated nature of the equilibrium game and the distributional assumptions about the shock, it seems
logical to interpret a time period in this model as being the several years that may encompass a financial or fiscal
crisis episode, which is still shorter than the length of some emerging market debt.

193

ex ante for the additional default risk. It seems that markets do not trust governments
to use this unilateral contingency tool, and so they have switched it off.21
Overall, the model provides a nice framework for considering government saving(or dissaving) decisions and how their interaction with the inability to enforce debt
contracts of sovereign nations generates different regions of debt behavior. It canalso match many stylized facts about debt default. But as with most models, theneed to keep it tractable limits its applicability to studying many real-world issues,particularly the dynamics of debt and default.

References

Caballero R., K. Cowan, and J. Kearns, “Fear of Sudden Stops: Lessons from Australia and Chile,” NBER
Working Paper No. 10519, National Bureau of Economic Research, 2004 (also presented at the
Financial Dedollarization Conference, Inter-American Development Bank, December, 2003).
Reinhart C. M., K. S. Rogoff, and M. A. Savastano, “Debt Intolerance,” Brookings Papers on Economic
Activity, 1, 2003, pp. 1–74.

General Discussion
Kenneth Kletzer agreed with the comments made by the discussants and emphasized
two points: the applicability of his model to non-emerging market countries andissues related to monetary policy. Regarding the applicability to non-emerging
markets, Kletzer first acknowledged that the feature of procyclical fiscal policy in themodel seemed to fit emerging market countries but added that this feature, which
was difficult to obtain from consumption-smoothing models, was not the emphasisof his paper. Instead, he emphasized that part of the purpose of his paper was tofocus on industrialized countries in a way that had not been done in the sovereign
debt literature.
Regarding the issues related to monetary policy, Kletzer stated that the incomplete
information structure adopted in his model made the fiscal incentives of the government consistent with the incentives for monetary stability—a feature often observedin industrialized countries.
Responding to Jonathan Kearns’ comment, Jeromin Zettelmeyer added that emerging markets might be accumulating debt close to the limit because they were facedwith highly volatile external shocks. Furthermore, by pointing out that these external
shocks are observable, Zettelmeyer questioned why there were no contingent claims
conditioned upon those external shocks and asked where the information asymmetry
was coming from. Kearns responded that there was a tendency toward information
asymmetry in a government’s fiscal and taxation policy mainly for political reasons.
In the general discussion, acknowledging the characterization of private information
by Kearns, Charles L. Evans (Federal Reserve Bank of Chicago) asked about the sourceof private information for the United States or other large economies where the21. Of course, there are also instances where domestic agents are obliged or coerced to hold domestic currency
debt instruments.

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General Discussion

market participants pay close attention to all the relevant information pertaining tofiscal and monetary policies. Kletzer noted that there might not be much private
information in the case of the United States. As for the emerging markets, Kletzer statedthat an example of private information was the government officials’ intentions regarding the future policy course, which were not revealed to the market participants.
Hiroshi Fujiki (Bank of Japan) suggested that it might be interesting to think about
an explanation for the notion of “original sin” in the context of this particular model.
Kletzer responded that the government assumed in this model would be forced toissue debt denominated in a foreign currency or indexed debt unless it achieved thereputational equilibrium. In this regard, Kletzer also argued that a government could
earn a reputation by issuing debt in foreign currencies or indexed debt because it might
be very costly to renegotiate the debt in foreign currencies or to renege on indexationof domestic debt.
Several questions were raised regarding the yield on government debt. Observing
that yield on debt is equal to the discount rate despite the existence of a government’s
default risk in the model, Naohiko Baba (Bank of Japan) pointed out that the setupof the model made the creditors risk neutral. He questioned what would happen if
we allowed for the existence of risk-averse creditors. David H. Bowman (Board ofGovernors of the Federal Reserve System) questioned how we should reconcile theimplications of the model with the fact that the governments of emerging markets
were constrained when rolling over short-term debt and the sovereign spreads wereconstantly in motion. Kletzer responded that, without the self-enforcement constraint,yield on government debt would be below the discount rate under the generalequilibrium setting and would be equal to the discount rate if the government were
faced with the two-sided constraints. In addition, Kletzer pointed out that yields on
debts that were frequently rolled over were highly volatile, especially in the emerging
markets. Appealing to the linkage between the volatility of the yields and the disclosureof public information, Kletzer commented that the symmetric information models
with a stochastic process proxying the payoff relevant information disclosure might
better explain the volatility of the yields.
Regarding the procyclical fiscal policy for emerging markets, Erdem Başçi(Central Bank of the Republic of Turkey) stated that a primary surplus would be anincreasing function of the debt ratio and conjectured that the model would imply aprocyclical fiscal policy by introducing default cost. Kletzer responded that theprocyclicality of fiscal policy could occur when government was relying on a noncontingent bond as a debt instrument and repayment was made with certainty. Whileacknowledging the idea of introducing default cost, Kletzer noted that such an idea issurprisingly difficult to implement.

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