Self-Fulfilling Debt Crises

Abstract

We characterize the values of government debt and the debt's maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country's fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government's debt. We show that this reduction can be gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.

Sovereign borrowing, financial assistance, and debt repudiation

“…They can borrow and lend at world financial markets at a risk-free interest rate r and are risk neutral. 6 Following Cole and Kehoe (2000), we allow for self-fulfilling crises during which a run by the investors triggers a government default. Given that in a certain period there is no run, the international investors' profit maximization implies the following bond price equation, which ensures zero profits in expectation:…”

“…In this case the government defaults for sure, independent of the rollover decision of the investors. 12 Cole and Kehoe (2000) outline a detailed within-period timing of actions that leads to this type of coordination game with the potential emergence of self-fulfilling crisis. 13 The position of V def DH (y) relative to V def D (h, y) depends on the level of outstanding bailout loans.…”

“…Our model is based on the standard sovereign default model à la Eaton and Gersovitz (1981) and builds on Cole and Kehoe (2000) by considering multiple equilibria due to runs by investors. The government of a small open economy can borrow both from private international investors and from an official lending facility.…”

“…Arellano (2008) studies the quantitative implications of this model by applying it to the Argentinean default event in 2001 and shows that a calibrated version of the model is able to replicate important features of the Argentinean data. Multiple equilibria in models of sovereign default have been analyzed by Calvo (1988) and Cole and Kehoe (1996;2000). In the Cole and Kehoe model there exists an interval of debt levels, the crisis zone, for which the government finds it optimal to default only in case it cannot issue new debt because of a run on the sovereign debt market.…”

Financial Crises as Herds: Overturning the Critiques

“…Assumption (9) implies that if an investor is forced to invest at the initial prior, this investor will invest a strictly positive amount in the risky project. Assumption (10) implies that if an investor is forced to invest at beliefs p(−1), this investor will invest nothing in the risky project.…”