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Self-inflicted Debt Crises

Author

Listed:
  • Theodosios Dimopoulos

    (University of Lausanne - School of Economics and Business Administration (HEC-Lausanne); Swiss Finance Institute)

  • Norman Schürhoff

    (University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR))

Abstract

In a dynamic model of optimal bailouts, we show how borrower myopia affects the severity of debt crises. Myopic borrowers misprice the option to default with a U-shaped negative pricing error. The myopia discount changes the optimal bailout policy. Myopia gets punished when the distortions from default mispricing outweigh the future bailout costs, resulting in procrastinated default and protracted crises. The model shows that (i) myopia is an important determinant for bailout policy, (ii) myopic default can be cheaper to resolve than rational default, (iii) rational agents can benefit from a myopic sovereign borrower, and (iv) credit spread dynamics are more asymmetric under myopia than rationality, consistent with empirical evidence.

Suggested Citation

  • Theodosios Dimopoulos & Norman Schürhoff, 2021. "Self-inflicted Debt Crises," Swiss Finance Institute Research Paper Series 21-11, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2111
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    JEL classification:

    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • G01 - Financial Economics - - General - - - Financial Crises
    • G4 - Financial Economics - - Behavioral Finance
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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