Gambling for redemption and self-fulfilling debt crises (original) (raw)
Related papers
Theory and evidence on self-fulfilling sovereign debt crises
2016
This work analyzes theoretically and empirically the potential self-fulfilling features of sovereign debt crisis. The theoretical model modifies Cole and Kehoe (1996, 2000) by considering that the default is partial. In the model, there are debt limits within which self-fulfilling crises may occur. The numerical results show that, within the crisis zone, up to an intermediate debt level, the optimal government policy is to run down the debt until it reaches the safe limit to avoid higher borrowing costs. Above a certain amount, however, the government chooses to run up the debt, to avoid sharp reduction in government spending. The empirical investigation assesses the determinants of the probability of default in Portugal. The model builds on Jeanne and Masson (2000) and is brought to Portuguese data using a Markov-switching regime framework. The results show that between 2000-14 two regimes subsisted: a tranquil and a crisis regime. The switch between regimes seems to be unrelated with macroeconomic fundamentals, which is interpreted as self-fulfilling jumps in the beliefs of credit markets.
A model of strategic default of sovereign debt
Journal of Economic Dynamics and Control, 1987
This paper presents a continuous-time stochastic model to study the timing decision of strategic default of sovereign debt. The debtor country precommits to an investment plan, finances part of it with a foreign loan, and maximizes the present value (PV) of utility from an infinite stream of consumption. Default risk arises from uncertainty surrounding the evolution of GDP over time. As the debt ratio increases, it introduces an increasing drag on the growth of GDP and also increases the risk premium on the loans, At each moment the nation must decide whether to service the loan over the next period (infinitesimally small) or to default, thereby gaining the PV of the loan, but correspondingly suffering a default penalty, and forgoing the option to default in the future. This choice is cast as a first-passage problem: default occurs (if and) when the PV of consumption under default first exceeds the PV given continuance of debt service. The actual values of the debt ratio for several debt-ridden countries is found to be close to the theoretically derived critical level. This framework also enables the study of austerity programs, rescheduling and other policy alternatives.
Sovereign Default Risk and Sustainable Fiscal Policy
Last years the world economy changed and the sovereign risk default increased dramatically for many countries. Countries like Greece, Iceland or Portugal needs special financial rescue plans. For these countries the main mistake was an imprudent fiscal and budgetary policy last years and also the lack of monetary policy independence. This paper examines the impact of fiscal policy on sovereign default risk on Romanian economy and the dynamic of country risk during global crisis. In order to analyze the sustainability of fiscal policy in Romania last years we propose a macroeconometrical model. We start from Buiter (1996) and Budina (1997) models and analysis and we develop a specific model studying the influence of fiscal policy on sovereign risk default in Romania. We test our results using Quintos (1995) and Trehan and Walsh (1988) sustainability tests and the result was conclusive.
Chronic sovereign debt crises in the Eurozone, 2010-2012
2012
Beginning in late 2009, the Greek government had difficulties selling its bonds to private investors, who demanded high interest rates. In May 2010, the European Union (EU) and the International Monetary Fund (IMF) approved a 110 billion euro loan package to the Greek government in return for promises of spending cuts to sharply reduce the Greek public deficit. The plan, negotiated by German Chancellor Angela Merkel and Greek Prime Minister George Papandreou, was intended to cover the borrowing needs of the Greek ...
European Debt Crisis and Fiscal Exit Strategies
The 2007-2009 financial crisis was caused by financial markets' greed and instability. The crisis led public debts and deficits to rise substantially in developed countries. Financial markets and international institutions claim for a "fiscal exit strategy" through rapid reductions in public deficits and substantial falls in public debts owing to large public spending cuts (especially social expenditure). The article shows that the state of public finances was generally satisfactory before the crisis; the rise in deficits was needed for macroeconomic stabilisation purposes and does not signal higher future interest rates or inflation. 'Crisis exit strategies' should keep interest rates at low levels and government deficits, as long as they are necessary to support activity; they should question financial globalisation and macroeconomic strategies in neo-mercantilist and in liberal countries. The crisis should not be an opportunity for leading classes and Europe...
SSRN Electronic Journal, 2000
This paper explains the eurozone debt crisis as the result of self-reinforcing debt-spirals, which were caused by different inflation rates across the EMU member states. According to this view, the current crisis is not the result of a speculative attack but of a design faulty of the EMU. The data presented support this view. Time series of government budget and current account surpluses are calculated, which are compatible with constant debt-to-GDP ratios. The results show that the situation has become critical for countries like Greece, Portugal, Spain and Ireland significantly before capital markets started to demand higher interest rate spreads.
In this paper, we propose a simple post-Keynesian model on the linkages between the financial and real side of an economy. We show how, according to the Minskyan instability hypothesis, financial variables, credit availability and asset prices in particular, may feedback each other and affect economic activity, possibly giving rise to intrinsically unstable economic processes. Through these destabilizing mechanisms, we also explain why governments intervention in the aftermath of the 2007 financial meltdown has been largely useless to restore financial tranquility and economic growth, but transformed a private debt crisis into a sovereign debt one. The paper ends up by looking at the long-run and to the interaction between long-term growth potential and public debtsustainability. We explicitly consider the Euro-zone economic context and the difficulties several EU members currently face to simultaneously support economic recovery and consolidate fiscal imbalances. We stress that: (i) financial turbulences may trigger permanent reductions in long-term growth potential and unsustainable public debt dynamics; (ii) strong institutional discontinuity such as Eurobond issuances may prove to be the only way to restore growth and ensure long-run public debt sustainability.
Curing and Preventing Euroarea’s Sovereign Debt Crises: Some Issues and a Recipe
SSRN Electronic Journal, 2012
This paper reviews the current global economic outlook. Specific focus is set on the situation Europe is facing. A possible way forward is outlined based on a stabilization of the banking system in the Eurozone, a structural reform agenda and ultimately steps towards fiscal harmonization. The negative consequences of this difficult environment for the financial sector and their implications for the real economy are then discussed. The paper concludes that a number of actions by companies, policymakers and regulators can contribute to improve the situation. 2.2. GLOBAL OUTLOOK Financial markets rallied strongly since the summer of 2012, but we should not mistake the signal this is giving us. The Eurozone crisis is not over. It is true that the European Central Bank (ECB) has been more explicit in spelling out its strategy for resolving crises, but the era of increased volatility and uncertainty continues, and markets remain at the behest of shifts in political risk, as we have seen recently in Italy for example. Previous rallies petered out once investors realized that Europe's longer-term problems remained unsolved. Statements from the ECB have helped buy time, but do not offer a long-term solution on their own.
A fiscal theory of sovereign risk
Journal of Monetary Economics, 2006
This paper presents a fiscal theory of sovereign risk and default. Under certain monetaryfiscal regimes, the risk of default, and thus the emergence of sovereign risk premia, are inevitable. The paper characterizes the equilibrium processes of the sovereign risk premium and the default rate under a number of alternative monetary policy arrangements. Under some of the policy environments considered, the expected default rate and the sovereign risk premium are zero although the government defaults regularly. Under other monetary regimes the default rate and the sovereign risk premium are serially correlated and therefore forecastable. Environments are characterized under which delaying default is counterproductive.
Sovereign Debt Management and Fiscal Vulnerabilities
A wide consensus has emerged on the role of debt management in reducing fiscal vulnerability by providing insurance against macroeconomic shocks to the government budget. Whether this goal is better accomplished by nominal or inflation-indexed debt, by a short or a long maturity structure, remains however controversial. In this paper we review the issues of indexation and debt maturity, discussing in particular the role of the maturity structure in light of integrated financial markets and the risk of default. We argue that the role of inflation-indexed debt as a hedge against demand and inflation shocks is less important when price stability is ensured by a Ricardian fiscal policy and an independent central bank. A strong case can instead be made for a long maturity structure to reduce interest-rate risk and, more importantly, the risk of default. The maturity of the debt is a key variable to assess the vulnerability of the government fiscal position and should deserve greater attention in debt sustainability analysis. Finally, we compare the theory of fiscal insurance to the debt managers' practice of minimizing the cost and risk of the interest expenditure. A concern for the cost of debt service is justified only if expected return differentials between debt instruments are determined by mispricing, market imperfections or liquidity, but not if higher risk premia reflect a fair price for insurance. Our analysis points to the danger of minimizing the interest expenditure over a short horizon as may happen in times of crisis, when the government strives to achieve budget balance. More generally, fiscal insurance cannot be evaluated using national accounts figures, such as the interest expenditure and the book value of the debt. The lack of a more theory-based accounting framework is indeed a major obstacle to optimal debt management.