When will solidarity, which emerges spontaneously from the fear of spillovers, be reinforced through contracting? The optimal pact between countries that differ substantially in their probability of distress is a simple debt contract with market financing, a borrowing cap, but no joint liability. While joint liability augments total surplus, the borrowing country cannot compensate the deep-pocket guarantor. By contrast, the optimal pact between two countries symmetrically exposed to shocks with an arbitrary correlation is a simple debt contract with joint liability, provided that shocks are sufficiently independent, spillovers sufficiently large, liquidity needs moderate, and available sanctions sufficiently tough.
ASJC Scopus subject areas
- Economics and Econometrics