ABSTRACT
This chapter elucidates the externalities that are associated with foreign borrowing where there is sovereign default risk. We also derive expressions for the optimal taxes needed to internalise them. We argue that this helps to clarify the debate about whether foreign debt is a ‘problem’, which should be addressed by government, or the efficient outcome of optimising decisions by individuals and something which the government should leave to be determined by market forces. In our view this debate comes down to an empirical question: how large are the optimal taxes needed to internalise the externalities associated with foreign debt?
