Sovereign Debt and Structural Reforms

We construct a dynamic theory of sovereign debt and structural reforms with limited enforcement and moral hazard. A sovereign country in recession would like to smooth consumption. It can also undertake costly reforms to speed up recovery. The sovereign can renege on contracts by suffering a stochastic cost. The Constrained Optimum Allocation (COA) prescribes non-monotonic dynamics for consumption and effort and imperfect risk sharing. The COA is decentralized by a competitive equilibrium with markets for renegotiable GDP-linked one-period debt. The equilibrium features debt overhang: reform effort decreases in a high debt range. We also consider environments with less complete markets.