What is the cost of sovereign default, and what makes default costly? This paper uses a novel econometric method – combining local projections and propensity score weighting as in Jordá and Taylor (2016) – to study these questions. We find that default generates a long-lasting output cost – 2.9% of GDP on impact and 4.4% at peak after five years – but in the longer term, economic activity recovers. The downturn is characterised by a collapse in investment and gross trade. The cost rises dramatically if the default is followed by a systemic banking crisis, peaking at 9.4% of GDP. Our findings suggest that while autarky plays an important role, sovereign-banking spillovers are central to the cost of default.
[Original May 2016, updated January 2018]