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Gambling for redemption and self-fulfilling debt crises

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Listed:
  • Juan Carlos Conesa

    (Stony Brook University)

  • Timothy J. Kehoe

    (University of Minnesota
    Federal Reserve Bank of Minneapolis
    National Bureau of Economic Research)

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.

Suggested Citation

  • Juan Carlos Conesa & Timothy J. Kehoe, 2017. "Gambling for redemption and self-fulfilling debt crises," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(4), pages 707-740, December.
  • Handle: RePEc:spr:joecth:v:64:y:2017:i:4:d:10.1007_s00199-017-1085-5
    DOI: 10.1007/s00199-017-1085-5
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    More about this item

    Keywords

    Debt crisis; Rollover crisis; Recession; Eurozone;
    All these keywords.

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles
    • H13 - Public Economics - - Structure and Scope of Government - - - Economics of Eminent Domain; Expropriation; Nationalization

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