Working Papers

We analyze the efficiency properties of competitive economies with strategic default and limited pledgeability. We show that laissez-faire equilibria can be constrained suboptimal: under certain conditions, imposing tighter borrowing constraints (relative to the laissez-faire regime) can make everybody in the economy better off. The inefficiency is due to the interaction between debt pricing and the default option, which generates a pecuniary externality. We also show that a Pigouvian subsidy on net financial positions may induce borrowers to internalize this externality and increase welfare.