When is it optimal for a government to default on its legal repayment oblig-
ations? We answer this question for a small open economy with domestic
production risk in which the government optimally finances itself by issuing
non-contingent debt. We show that Ramsey optimal policies occasionally devi-
ate from the legal repayment obligation and repay debt only partially, even if
such deviations give rise to significant default costs. Optimal default improves
the international diversification of domestic output risk, increases the efficiency
of domestic investment and - for a wide range of default costs - significantly
increases welfare relative to a situation where default is simply ruled out from
Ramsey optimal plans. We show analytically that default is optimal following
adverse shocks to domestic output, especially for very negative international
wealth positions. A quantitative analysis reveals that for empirically plausible
wealth levels, default is optimal only in response to disaster-like shocks to do-
mestic output, and that default can be Ramsey optimal even if the net foreign
asset position is positive.
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