Optimal Domestic Sovereign Default

Infrequent but dramatic episodes of outright default on domestic sovereign debt are an important historical fact that remains unexplained. We propose an incomplete-markets, heterogeneous-agents model in which domestic default can be optimal for a utilitarian government that responds to distributional incentives. The government finances the gap between stochastic expenditures and lump-sum taxes by issuing non–state-contingent debt, but it retains the option to default. The distribution of public debt across private agents is endogenous and interacts with the government's optimal default, debt issuance and tax decisions. Repaying is beneficial because it allows the government to access the debt market and provides a mechanism for households to self insure and smooth consumption, but it also increases the need for future tax revenues. Default is optimal when repaying hurts relatively poor agents more than defaulting hurts relatively rich agents, and this occurs along an equilibrium path when public debt is high enough and its ownership is sufficiently concentrated. Unlike standard models of external sovereign default, the model supports realistic debt-output ratios on average (40%) and before default (60%) at a nontrivial default frequency (8%).