This paper by Paul Krugman examines the trade-offs faced by creditors of countries with large debts that cannot attract new lending. The authors explore two main options: financing the country at an expected loss or forgiving the debt. Financing gives creditors an option value, hoping that the country will eventually repay, while forgiveness reduces the debt level to a manageable amount. The paper argues that the choice between these options is a trade-off, with financing potentially distorting the country's incentives due to the benefits of good performance going mostly to creditors. It also suggests that improving this trade-off can be achieved by making both financing and forgiveness contingent on factors beyond the country's control, such as oil prices or world interest rates. The paper further discusses various proposals for dealing with the debt problem, including the Baker initiative and the Bradley Plan, and highlights the need for innovative approaches that may involve changes in the nature of claims on developing countries. The analysis concludes that linking repayment to measures of economic conditions, such as the state of nature, could be beneficial for both debtors and creditors.This paper by Paul Krugman examines the trade-offs faced by creditors of countries with large debts that cannot attract new lending. The authors explore two main options: financing the country at an expected loss or forgiving the debt. Financing gives creditors an option value, hoping that the country will eventually repay, while forgiveness reduces the debt level to a manageable amount. The paper argues that the choice between these options is a trade-off, with financing potentially distorting the country's incentives due to the benefits of good performance going mostly to creditors. It also suggests that improving this trade-off can be achieved by making both financing and forgiveness contingent on factors beyond the country's control, such as oil prices or world interest rates. The paper further discusses various proposals for dealing with the debt problem, including the Baker initiative and the Bradley Plan, and highlights the need for innovative approaches that may involve changes in the nature of claims on developing countries. The analysis concludes that linking repayment to measures of economic conditions, such as the state of nature, could be beneficial for both debtors and creditors.