Gambling for redemption and self-fulfilling debt crises

Juan Carlos Conesa, Timothy J. Kehoe

Research output: Contribution to journalArticlepeer-review

10 Scopus citations

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 also has an incentive to smooth consumption and increase debt. Our exercise identifies conditions on fundamentals for which the incentive to smooth consumption dominates, giving rise to a situation where governments optimally “gamble for redemption,” running fiscal deficits and increasing their debt, thereby increasing their vulnerability to crises.

Original languageEnglish (US)
Pages (from-to)707-740
Number of pages34
JournalEconomic Theory
Volume64
Issue number4
DOIs
StatePublished - Dec 1 2017

Bibliographical note

Funding Information:
We thank Tito Cordella, Isabel Correia, Patrick Kehoe, Narayana Kocherlakota, David Levine, Thomas Lubik, Fabrizio Perri, and Pedro Teles, as well as participants at numerous conferences and seminars, for helpful discussions. We also thank Jose Asturias, Wyatt Brooks, Daniela Costa, Laura Sunder-Plassmann, and Gajendran Raveendranathan for excellent research assistance. The research has been supported by the European Union’s 7th Framework Collaborative Project Integrated Macro-Financial Modelling for Robust Policy Design (MACFINROBODS), Grant 612796, and by the National Science Foundation through Grant SES-0962993. All of the data used in this paper are available at www.econ.umn.edu/~tkehoe. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

Keywords

  • Debt crisis
  • Eurozone
  • Recession
  • Rollover crisis

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