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Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don't Avert Macroeconomic Crises

  • Joshua Aizenman
  • Kenneth M. Kletzer
  • Brian Pinto

This paper argues that the frequent failure of the debt swaps is not an accident. Instead, it follows from fundamental forces driven by the market's assessment of the scarcity of fiscal revenue relative to the demand for fiscal outlays. It follows from the observation that arbitrage forces systematically impact prices in asset markets. Ignoring these price adjustments would lead to too optimistic an assessment of the gains from swaps or buybacks. A by-product of our paper is to highlight the perils of financial engineering that ignores the intertemporal constraints imposed by fiscal fundamentals. As a country approaches the range of partial default (either on domestic or external debt), swaps may not provide the expected breathing room and could even bring the crisis forward. Our methodology combines three independent themes: exchange rate crises as the manifestation of excessive monetary injections [Krugman-Flood-Garber], the fiscal theory of inflation [Sargent-Wallace (1981)], and sovereign debt. The integrated framework derives devaluation and external debt repudiation as part of a public-finance optimizing problem. We shows that under conditions similar to those which prevailed in Russia and Argentina prior to their meltdown, swaps are not just neutral, but could actually make the situation worse and even trigger a speculative attack. An unsettlingly clear implication of the model is that there may be very few options left once public debt reaches levels regarded as unsustainable in relation to fiscal fundamentals. Dollarization only makes matters worse, and pushes the debt write-down option to the fore.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9190.

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Date of creation: Sep 2002
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Publication status: published as Aizenman, Joshua, Kenneth M. Kletzer and Brian Pinto. "Sargent-Wallace Meets Krugman-Flood-Garber, Or: Why Sovereign Debt Swaps Do To Avert Macroeconomic Crises," Economic Journal, 2005, v115(503,Apr), 343-367.
Handle: RePEc:nbr:nberwo:9190
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  1. Jeremy Bulow & Kenneth Rogoff, 1988. "The Buyback Boondoggle," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(2), pages 675-704.
  2. Kenneth M. Kletzer and Brian D. Wright., 1998. "Sovereign Debt as Intertemporal Barter," Center for International and Development Economics Research (CIDER) Working Papers C98-100, University of California at Berkeley.
  3. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  4. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  5. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  6. Kenneth Kang & Hong Liang & Henry Ma & Anthony J. Richards & Ajai Chopra & Meral Karasulu, 2001. "From Crisis to Recovery in Korea; Strategy, Achievements, and Lessons," IMF Working Papers 01/154, International Monetary Fund.
  7. Michael Mussa, 2002. "Argentina and the Fund: From Triumph to Tragedy," Peterson Institute Press: All Books, Peterson Institute for International Economics, number pa67, May.
  8. Homi Kharas & Brian Pinto & Sergei Ulatov, 2001. "An Analysis of Russia's 1998 Meltdown: Fundamentals and Market Signals," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 32(1), pages 1-68.
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