Debt forgiveness: the case for hyper-incentive contracts

Working paper

We review two proposals for debt forgiveness; the Highly Indebted Poor Country Initiative (HIPC) and the Jubilee 2000 Coalition Initiative (J2K). We then consider the workhorse model of debt forgiveness (Krugman 1988). We show that the workhorse model solution is a sub-optimal contract, where the incentive parameter is set without regard to the cost of effort. A fully-optimal debt-overhang contract is derived, with an incentive parameter greater than the marginal social benefit of extra effort. The so-named Hyper-Incentive Contract eliminates the effects of moral hazard arising from hidden effort, and provides a fuller rationale for case-by-case debt-overhang contracts.

Authors: Menzies, G

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2000-10-01
• Paper number: 37
• Keywords: debt forgiveness; optimal contracts; debt overhang; moral hazard