Report

Gambling for redemption and self-fulfilling debt crises

Abstract: We develop a model for analyzing the sovereign debt crises of 2010?2012 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.

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2012

Number: 465