Self-fulfilling Prophecies in Sovereign Debt Markets

In this paper, we discuss conditions under which adverse expectations can trigger abrupt and large changes in the interest rate at which a sovereign country can borrow in international financial markets. We argue that such changes are caused by self-fulfilling expectations outcomes, in which interest rates are high because the perceptions of future defaults are high, but those perceptions are high precisely because the interest rates are high. {{p}} A model based on these elements successfully simulates the near-default experience of Greece, Italy, Spain and Portugal, among other countries. We show that self-fulfilling traps can occur when two conditions are met: First, the existing level of government debt must be relatively high; second, the probability that the country faces a long period of economic stagnation must be substantial. {{p}} We also show that if a sufficiently large institution is willing to lend to the country, these self-fulfilling traps can be eliminated. Our model thus suggests that the Outright Monetary Transactions (OMT) program adopted by the European Central Bank in the summer of 2012 saved southern European countries from a massive sovereign debt crisis.