Default and E±cient Debt Markets

We consider the extent of debt, and the nature of debt contracts, if borrowers can default on debts, in an in ̄nite horizon economy with a productive, intertemporal technology. Some individuals own this technology; the rest lend their savings to them. Borrowers can default on debt at any time, and lose the right to borrow if they do so. We evaluate debt and repayment paths that can be sustained by this penalty. The set of allocations that can be supported by such default-free debt paths is fully characterized; this set is non-empty, convex, and contains a subset that is fully e±cient. We then analyse the properties of e±cient, sustainable allocations and their decentralization. Debt contracts that involve two-part pricing are shown to support e±cient allocations subject to the no-default constraint. E±ciency is compatible with anonymous contracts.