Default and Enforcement Constraints

This article illustrates when limited enforcement of contracts induces enforcement constraints (limits to intertemporal exchange) or default (the breaking of intertemporal promises with the associated punishment), and sheds light on how enforcement policies should be related to the observed frequency of default. When limited enforcement is the only friction, equilibrium default is never observed, yet tightening enforcement of contracts is socially beneficial. When limited enforcement coexists with other frictions, default occurs in equilibrium, but tightening enforcement might be socially undesirable. The reason is that equilibrium default, although detrimental to intertemporal exchange, might lead to improved allocation of resources across states.