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.
File(s): File format is application/pdf http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4923
Provider: Federal Reserve Bank of Minneapolis
Part of Series: Staff Report
Publication Date: 2012