The Aftermath of Sovereign Debt Crises: A Narrative Approach

Default is as old as sovereign debt. Since 1820, countries that issued sovereign debt have spent 18% of time in a state of default. Despite the scale of the problem, the causes and consequences of defaults are still imperfectly understood. In this paper we quantify the aggregate cost of defaults, based on a large panel of 50 sovereigns between 1870 and 2010. Since defaults are endogenous to the business cycle, we use the narrative approach to identify plausibly exogenous debt crises. Our estimates yield significant and persistent costs of defaults starting at 1.6% of GDP and peaking at 3.3% before reverting to trend five years after a debt event. Moreover, we identify a large heterogeneity of costs by the cause of default. Higher costs are associated with defaults initiated by negative supply shocks, political crises, or adverse terms of trade. In contrast, domestic demand shocks have a moderate effect, quickly reversed. Despite working with a large sample, we document how average estimates of default costs can be sensitive to different dating and definitions of defaults.