Foreign Debt and the Ricardian Equivalence

This paper shows that Bulow and Rogoff's "no sovereign lending" result does not apply in non-Ricardian economies. When a government strictly prefers debt-based to tax-based funding, an endogenous cost arises, prompting the government to repay. More accurately, a government which does not have enough tools to reach the first best (in which the Ricardian equivalence holds), cannot afford to redistribute the gains from default, and therefore net losses to agents will emerge in the economy. Finally, when foreign debt levels are small, the gains of default do not balance these losses.