Aggregate Demand and Sovereign Default
If a sovereign can’t collect enough taxes to pay it’s debt, it needs to decide whether to print away the debt, default on it, do austerity (increase taxes and decrease spending), or some combination. Each option has various impacts on aggregate demand and deadweight loss.
If your debt is denominated in your own currency and you have a printing press, you are never insolvent. The government can always use monetization to get rid of the debt. However, simply printing the money to pay off the debt will cause hyperinflation, a process significantly more damaging to the economy than outright default. A country like Greece, which does not control the currency its debts are denominated in, cannot chose to print its way out of a default crisis.
Government bonds, when sold, take purchasing power from the individuals who buy them and give that purchasing power to the government. When the debt is paid off, purchasing power is shifted from taxpayers to bondholders (who may even be the same person). Default creates a transfer from bondholders to future taxpayers who no longer have to pay for the debt. While the winners and losers perfectly balance out in terms of wealth, in the short run, default would likely reduce aggregate demand.
If the government were to default, the banking system would totally collapse. Banks use government debt as collateral for their loans, and if government debt dropped suddenly in value, those loans would become a lot more risky. Simultaneously, a significant portion of a bank’s assets could drop in value as well. Bankruptcy is quite costly and when one bank failed, it would be forced to sell off assets, dropping their value, and renege on its obligations to other financial institutions. As the 2007 financial crisis showed, banks are quite interconnected and trying to figure out who owes what to whom is quite difficult. As the banks collapsed, so too would lending causing an unwinding of the money multiplier. I think all of such chaos would be quite contractionary in the absense of a central bank response. Furthermore, I doubt a human controlled central bank would be able to respond with sufficient speed and finesse to stabilize NGDP.
Raising taxes and cutting spending reduces aggregate demand, ceteris paribus. You can think of taxes as the government taking money out of the economy, and spending it putting it back in. If wasteful spending were cut, there may be improvement in productivity and hence the real economy could grow (“expansionary fiscal contraction“). However, from a purely nominal side, there would be less money and government bonds in the economy, and hence less demand.
Since printing money to pay off the debt is inflationary and default and austerity are contractionary, I think it would be possible to maintain stable NGDP while defaulting. The government would have to use futures markets to figure out the ratio of default/austerity to printing.
Sovereigns have no real assets to speak of outside of their ability to tax and they hold a comparative advantage in violence over their subjects. No one can force them to go to court and auction off assets like a bankrupt corporation. The only things that people can really do to a country defaulting is invade and seize assets militarily or stop lending them money. Loss of ability to borrow has the advantage of forcing the government to run a mostly balanced budget for a few years.