This article reviews the literature on sovereign debt, that is, debt issued by a national government. The defining characteristic of sovereign debt is the limited mechanisms for enforcement. Because a sovereign government does not face legal consequences of default, the reasons why it makes repayment are to avoid default penalties related to reputation loss or economic cost. Theoretical and quantitative studies on sovereign debt have investigated the cause and impact of sovereign default and produced analysis of policy relevance. This article reviews the theories that quantitatively account for key empirical facts about sovereign debt. These studies enable researchers and policy makers to better understand sovereign debt crises.
Article
Sovereign Debt: Theory
Vivian Zhanwei Yue and Bin Wei
Article
Sparse Grids for Dynamic Economic Models
Johannes Brumm, Christopher Krause, Andreas Schaab, and Simon Scheidegger
Solving dynamic economic models that capture salient real-world heterogeneity and nonlinearity requires the approximation of high-dimensional functions. As their dimensionality increases, compute time and storage requirements grow exponentially. Sparse grids alleviate this curse of dimensionality by substantially reducing the number of interpolation nodes, that is, grid points needed to achieve a desired level of accuracy. The construction principle of sparse grids is to extend univariate interpolation formulae to the multivariate case by choosing linear combinations of tensor products in a way that reduces the number of grid points by orders of magnitude relative to a full tensor-product grid and doing so without substantially increasing interpolation errors. The most popular versions of sparse grids used in economics are (dimension-adaptive) Smolyak sparse grids that use global polynomial basis functions, and (spatially adaptive) sparse grids with local basis functions. The former can economize on the number of interpolation nodes for sufficiently smooth functions, while the latter can also handle non-smooth functions with locally distinct behavior such as kinks. In economics, sparse grids are particularly useful for interpolating the policy and value functions of dynamic models with state spaces between two and several dozen dimensions, depending on the application. In discrete-time models, sparse grid interpolation can be embedded in standard time iteration or value function iteration algorithms. In continuous-time models, sparse grids can be embedded in finite-difference methods for solving partial differential equations like Hamilton-Jacobi-Bellman equations. In both cases, local adaptivity, as well as spatial adaptivity, can add a second layer of sparsity to the fundamental sparse-grid construction. Beyond these salient use-cases in economics, sparse grids can also accelerate other computational tasks that arise in high-dimensional settings, including regression, classification, density estimation, quadrature, and uncertainty quantification.
Article
Tariffs and the Macroeconomy
Xiangtao Meng, Katheryn N. Russ, and Sanjay R. Singh
For hundreds of years, policymakers and academics have puzzled over how to add up the effects of trade and trade barriers on economic activity. The literature is vast. Trade theory generally focuses on the question of whether trade or trade barriers, like tariffs, make people and firms better off using models of the real economy operating at full employment and a net-zero trade balance. They yield powerful fundamental intuition but are not well equipped to address issues such as capital accumulation, the role of exchange rate depreciation, monetary policy, intertemporal optimization by consumers, or current account deficits, which permeate policy debates over tariffs. The literature on open-economy macroeconomics provides additional tools to address some of these issues, but neither literature has yet been able to answer definitively the question of what impact tariffs have on infant industries, current account deficits, unemployment, or inequality, which remain open empirical questions. Trade economists have only begun to understand how multiproduct retailers affect who ultimately pays tariffs and still are struggling to meaningfully model unemployment in a tractable way conducive to fast or uniform application to policy analysis, while macro approaches overlook sectoral complexity. The field’s understanding of the importance of endogenous capital investment is growing, but it has not internalized the importance of the same intertemporal trade-offs between savings and consumption for assessing the distributional impacts of trade on households. Dispersion across assessments of the impacts of the U.S.–China trade war illustrates the frontiers that economists face assessing the macroeconomic impacts of tariffs.
Article
Taxation in the Open Economy
Kimberly A. Clausing
The international mobility of capital presents important tax policy challenges, as the scope of economic activity exceeds the reach of national governance. Consequently, countries’ tax policy choices have important spillover effects outside of their own borders. For example, in the context of mobile multinational companies, countries that charge high tax rates may benefit their trading partners by increasing the competitiveness of their companies, while countries lowering tax rates have negative consequences for the competitiveness of trading partners’ firms. Further, countries’ noncooperative tax policy choices may entail too low tax rates (and too lax tax regimes), since they do not fully internalize the negative consequences of their choices on their partners, nor do they account for the dynamic effects of their choices on policy evolution abroad.
Climate policy also generates important spillovers. Since greenhouse gas emissions are a truly global externality and the benefits of any mitigation policy action are only partially captured by the government undertaking the effort, countries will have an incentive to free ride on the efforts of others. Beyond this free-riding problem, there are also competitiveness spillovers. For example, governments imposing costs on their emissions-intensive firms put them at a disadvantage relative to firms abroad, whereas governments subsidizing clean energy advantage their energy-intensive firms in the competitive marketplace. This dynamic makes it more difficult for countries to adopt cost-imposing policies.
Both of these policy spheres demonstrate the value of international tax policy coordination. The international tax agreement of 2021, in the process—as of 2023—of being implemented across the world, provides one possible model for enhanced coordination. So far, international climate policy lacks a similarly strong coordinated policy effort, but possible models include building from the European Union’s proposed carbon border adjustment and considering adoption of a climate club.
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The Economics of Innovation, Knowledge Diffusion, and Globalization
Nelson Lind and Natalia Ramondo
A recent body of literature on quantitative general equilibrium models links the creation and diffusion of knowledge and technology to openness to international trade and to the activity of multinational firms. The unifying theme of this literature is methodological: productivities are Fréchet random variables and arise from Poisson innovation and diffusion processes for ideas. The main advantage of this modeling strategy is that it delivers closed-form solutions for key endogenous variables that have a direct counterpart in the data (e.g., prices, trade flows). This tractability makes the connection between theory and data transparent, helps clarify the determinants of the gains from openness, and facilitates the calculation of counterfactual equilibria.
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The Economics of International Wage Differentials and Migration
Lant Pritchett and Farah Hani
The key question for the economics of international migration is whether observed real wage differentials across countries for workers with identical intrinsic productivity represent an economic inefficiency sustained by legal barriers to labor mobility between geographies. A simple comparison of the real wages of workers with the same level of formal schooling or performing similar occupations across countries shows massive gaps between rich and poorer countries. These gaps persist after adjusting for observed and unobserved human capital characteristics, suggesting a “place premium”—or space-specific wage differentials that are not due to intrinsic worker productivity but rather are due to a misallocation of labor. If wage gaps are not due to intrinsic worker productivity, then the incentive for workers to move to richer countries is high. The idea of a place premium is corroborated by macroeconomic evidence. National accounts data show large cross-country output per worker differences, driven by the divergence of total factor productivity. The lack of convergence in total factor productivity and corresponding spatial productivity differentials create differences in the marginal product of factors, and hence persistent gaps in the wages of equal productivity workers. These differentials can equalize with factor flows; however their persistence and large magnitude in the case of labor, suggest legal barriers to migration restricting labor flows are in fact constraining significant return on human capital, and leaving billions in unrealized gains to the world’s workers and global economy. A relaxation of these barriers would generate worker welfare gains that dwarf gold-standard poverty reduction programs.
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The Fundamentals of Arbitration
Susan Franck
Used for hundreds of years and adapted to a variety of contexts, arbitration is a form of adjudicative dispute settlement where parties consent to selecting third-party neutrals that resolve a specific dispute by applying the applicable law to the facts. Part of arbitration’s success involves its flexibility in adapting procedures and selecting applicable law to meet parties’ unique needs, including having some control over the appointment of an arbitrator who may have unique substantive expertise. Parties may agree to arbitration hoping to avoid the time-consuming, expensive, and complex process of litigation by streamlining or tailoring dispute mechanics. Yet, it is not empirically verifiable that arbitration always saves time and costs, as assessing relative savings requires comparison to a national court and there are over 190 national judiciaries to which arbitration could be compared, as well as nonadjudicative forms of dispute resolution like direct negotiation and mediation. As parties inevitably negotiate in the “shadow of the law,” arbitration aids the assessment of conflict management options; and, particularly internationally, arbitration remains a powerful tool that incentivizes voluntary compliance with awards and streamlines enforcement.
Despite the availability of many types of arbitration with different policy considerations, the parties’ consent to it and their agreement to arbitrate (including the applicable law) is the backbone of this form of dispute settlement. Arbitration agreements require parties to make core choices, such as deciding on the scope of agreements submitted to arbitration, the legal place of arbitration, and applicable rules. Such an agreement then provides the framework for fundamental elements of the proceedings, namely, the basis of the tribunal’s jurisdiction and power over the dispute, the standards for appointing arbitrators, the structure and rules of the proceedings, and the content and form of derivative awards. Having a valid arbitration agreement (and an arbitration proceeding conducted in accordance with those legal obligations) also influences whether courts at the place of arbitration will set the award aside and whether courts at a place of enforcement will recognize and enforce an arbitration award. In the modern era, arbitration will continue evolving to address concerns about local policy considerations (particularly in national arbitration), confidentiality and ethics, technology and cybersecurity, diversity and inclusion, and to ensure arbitration is an ongoing value proposition.
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Trade Agreements: Theoretical Foundations
Mostafa Beshkar and Eric Bond
International trade agreements have played a significant role in the reduction of trade barriers that has taken place since the end of World War II. One objective of the theoretical literature on trade agreements is to address the question of why bilateral and multilateral trade agreements, rather than simple unilateral actions by individual countries, have been required to reduce trade barriers. The predominant explanation has been the terms of trade theory, which argues that unilateral tariff policies lead to a prisoner’s dilemma due to the negative effect of a country’s tariffs on its trading partners. Reciprocal tariff reductions through a trade agreement are required to obtain tariff reductions that improve on the noncooperative equilibrium. An alternative explanation, the commitment theory of trade agreements, focuses on the use of external enforcement under a trade agreement to discipline domestic politics.
A second objective of the theoretical literature has been to understand the design of trade agreements. Insights from contract theory are used to study various flexibility mechanisms that are embodied in trade agreements. These mechanisms include contingent protection measures such as safeguards and antidumping, and unilateral flexibility through tariff overhang. The literature also addresses the enforcement of agreements in the absence of an external enforcement mechanism. The theories of the dispute settlement process of the WTO portray it as an institution with an informational role that facilitates the coordination among parties with incomplete information about the states of the world and the nature of the actions taken by each signatory. Finally, the literature examines whether the ability to form preferential trade agreements serves as a stumbling block or a building block to multilateral liberalization.
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Trade Finance and Payment Methods in International Trade
JaeBin Ahn
International transactions are riskier than domestic transactions for several reasons, including, but not limited to, geographical distance, longer shipping times, greater informational frictions, contract enforcement, and dispute resolution problems. Such risks stem, fundamentally, from a timing mismatch between payment and delivery in business transactions. Trade finance plays a critical role in bridging the gap, thereby overcoming greater risks inherent in international trade. It is thus even described as the lifeline of international trade, because more than 90% of international transactions involve some form of credit, insurance, or guarantee. Despite its importance in international trade, however, it was not until the great trade collapse in 2008–2009 that trade finance came to the attention of academic researchers.
An emerging literature on trade finance has contributed to providing answers to questions such as: Who is responsible for financing transactions, and, hence, who would need liquidity support most to sustain international trade? This is particularly relevant in developing countries, where the lack of trade finance is often identified as the main hindrance to trade, and in times of financial crisis, when the overall drying up of trade finance could lead to a global collapse in trade.
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Trade Liberalization and Informal Labor Markets
Lourenço S. Paz and Jennifer P. Poole
In recent decades, economic reforms and technological advances have profoundly altered the way employers do business—for instance, the nature of employment relationships, the skills firms demand, and the goods and services they produce and export. In many developing economies, these changes took place concurrently with a substantive rise in work outside of the formal economy. According to International Labour Organization estimates, informal employment can be as high as 88% of total employment in India, almost 50% in Brazil, and around 35% of employment in South Africa. Such informal employment is typically associated with lower wages, lower productivity, poorer working conditions, weaker employment protections, and fewer job benefits and amenities, and these informal workers are often poorer and more vulnerable than their counterparts in the formalized economy. Informal jobs are a consequence of labor market policies—like severance payments or social security contributions—that make the noncompliant informal job cheaper for the employer than a compliant formal job. Each model has a different benefit (or lack of punishment) for employing formal workers, and a distinct mechanism through which international trade shocks alter the benefit-cost of these types of jobs, which in turn results in a change in the informality share. The empirical literature concerning international trade and formality largely points to an unambiguous increase in informal employment in the aftermath of increased import competition. Interestingly, increased access to foreign markets, via liberalization of major trading partners, offers strongly positive implications for formal employment opportunities, decreasing informality. Such effects are moderated by the de facto enforcement of labor regulations. Expansions toward the formal economy and away from informal wage employment in the aftermath of increased access to foreign markets are smaller in strictly enforced areas of the country.
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Trade Shocks and Labor-Market Adjustment
John McLaren
When international trade increases, either because of a country’s lowering its trade barriers, a trade agreement, or productivity surges in a trade partner, the surge of imports can cause dislocation and lowered incomes for workers in the import-competing industry or the surrounding local economy. Trade economists long used static approaches to analyze these effects on workers, assuming either that workers can adjust instantly and costlessly, or (less often) that they cannot adjust at all. In practice, however, workers incur costs to adjust, and the adjustment takes time. An explosion of research, mostly since about 2008, has explored dynamic worker adjustment through change of industry, change of occupation, change of location, change of labor-force participation, adjustment to change in income, and change in marital status or family structure.
Some of these studies estimate rich structural models of worker behavior, allowing for such factors as sector-specific or occupation-specific human capital to accrue over time, which can be imperfectly transferable across industries or occupations. Some allow for unobserved heterogeneity across workers, which creates substantial technical challenges. Some allow for life-cycle effects, where adjustment costs vary with age, and others allow adjustment costs to vary by gender. Others simplify the worker’s problem to embed it in a rich general equilibrium framework.
Some key results include: (a) Switching either industry or occupation tends to be very costly; usually more than a year’s average wages on average. (b) Given that moving costs change over time and workers are able to time their moves, realized costs are much lower, but the result is gradual adjustment, with a move to a new steady state that typically takes several years. (c) Idiosyncratic shocks to moving costs are quantitatively important, so that otherwise-identical workers often are seen moving in opposite directions at the same time. These shocks create a large role for option value, so that even if real wages in an industry are permanently lowered by a trade shock, a worker initially in that industry can benefit. This softens or reverses estimates of worker losses from, for example, the China shock. (d) Switching costs vary greatly by occupation, and can be very different for blue-collar and white-collar workers, for young and old workers, and for men and women. (e) Simple theories suggest that a shock results in wage overshooting, where the gap in wages between highly affected industries and others opens up and then shrinks over time, but evidence from Brazil shows that at least in some cases the wage differentials widen over time. (f) Some workers adjust through family changes. Evidence from Denmark shows that some women workers hit by import shocks withdraw from the labor market at least temporarily to marry and have children, unlike men.
Promising directions at the frontier include more work on longitudinal data; the role of capital adjustment; savings, risk aversion and the adjustment of trade deficits; responses in educational attainment; and much more exploration of the effects on family.
