On the sovereign debt paradox

Abstract

Bulow and Rogoff (Am Econ Rev 79(1):43-50, 1989) show that lending to small countries cannot be supported merely on the country's 'reputation for repayment' if exclusion from future credit markets is the only consequence of default. Their arguments are valid under fairly general conditions, but they do not go through when the output of the sovereign may vanish along a path of successive low productivity shocks, or when it may grow unboundedly along a path of successive high productivity shocks. We propose an alternative proof illustrating that their renowned sovereign debt paradox holds in full generality.