Report

Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models

Abstract: We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are: (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default; both are realistic and standard assumptions in the quantitative literature. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional ?lender of last resort? policies.

Keywords: Self-fulfilling debt crises; Sovereign debt; Debt dilution; Multiple equilibria;

JEL Classification: F34;

https://doi.org/10.21034/sr.565

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2018-05-30

Number: 565

Pages: 67 pages