Gambling for Redemption and Self-Fulfilling Debt Crises

Abstract

We develop a model for analyzing the sovereign debt crises of 2010-2013 in the Eurozone. The government sets its expenditure-debt policy optimally. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfilling crises in which investors, anticipating a crisis, are unwilling to buy the bonds, thereby provoking the crisis. In this situation, the optimal policy of the government is to reduce its debt to a level where crises are not possible. If, however, the economy is in a recession where there is a positive probability of recovery in fiscal revenues, the government may optimally choose to "gamble for redemption," running deficits and increasing its debt, thereby increasing its vulnerability to crises.

Sovereign default: The role of expectations

“…9 An increase in b shifts the curve h downward so that the solutions for b are closer to each other. The function h (R; b) does not need to be concave everywhere; this will depend on the cumulative distribution F (1 + bR).…”

“…9 The black vertical dotted lines are grid lines. We kept them in the plots throughout the paper to make the exposition clearer.…”

Is It Too Late to Bail Out the Troubled Countries in the Eurozone?

“…It can reduce its debt to escape the crisis zone so as to reduce the interest that it pays on its debt and eliminate the possibility of incurring the default penalty or it can increase its debt to smooth spending and gamble for redemption. Conesa and Kehoe (2012) find that the optimal government policy depends on the parameters of the model. In particular, the government runs down the debt if interest rates are high ( is large), the costs of default are high (1 Z  is large), the recession is mild (1 A  is small), and the probability of recovery is low ( p is small).…”

“…We modify the numerical experiment in Conesa and Kehoe (2012) to provide some illustrations of the sorts of results that the model produces. A period is one year, and we model bonds having an average maturity of six years using the specification of Chatterjee and Eyigungor (2012):…”

“…Our paper builds on the analysis of the debt crises in the Eurozone of Conesa and Kehoe (2012), which in turn builds on the analysis of the Mexican debt crisis of Kehoe (1996, 2000 …”