Optimal Debt and Endogenous Growth in Models of International Finance

The International Monetary Fund, the World Bank and the bond rating agencies did not anticipate the crises in Asia 1997-98 and in Argentina 2001. With this statement in mind, we consider some multi-stage inter-temporal stochastic optimisation models in international finance that imply theoretically founded and empirically measurable Early Warning Signals. The mathematical technique is dynamic programming/stochastic optimal control (DP/SOC). The variables of interest are the optimal foreign debt, consumption, capital and the growth rate of GDP. They are used as benchmarks of economic performance. By comparing the actual debt to the optimal debt we derive a measure of the sustainability of the debt and vulnerability to default problems. The two sources of uncertainty - the productivity of capital and the real interest rate on the foreign debt - are modeled as stochastic processes. Specific applications of the DP/SOC techniques are given for country defaults in Asia and Latin America, and the US current account deficits