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

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  • Joshua Aizenman
  • Kenneth M. Kletzer
  • Brian Pinto

Abstract

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.

Suggested Citation

  • Joshua Aizenman & Kenneth M. Kletzer & Brian Pinto, 2002. "Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don't Avert Macroeconomic Crises," NBER Working Papers 9190, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:9190
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    References listed on IDEAS

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    1. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
    2. Brian D. Wright & Kenneth M. Kletzer, 2000. "Sovereign Debt as Intertemporal Barter," American Economic Review, American Economic Association, vol. 90(3), pages 621-639, June.
    3. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-325, August.
    4. Kenneth H 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.
    5. 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.
    6. 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.
    7. 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.
    8. Michael Mussa, 2002. "Argentina and the Fund: From Triumph to Tragedy," Peterson Institute Press: Policy Analyses in International Economics, Peterson Institute for International Economics, number pa67, February.
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    Citations

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    Cited by:

    1. Garima Vasishtha, 2010. "Domestic versus External Borrowing and Fiscal Policy in Emerging Markets," Review of International Economics, Wiley Blackwell, vol. 18(5), pages 1058-1074, November.
    2. Joshua Aizenman, 2005. "Financial Liberalisations in Latin America in the 1990s: A Reassessment," The World Economy, Wiley Blackwell, vol. 28(7), pages 959-983, July.
    3. Asongu, Simplice & Raheem, Ibrahim & Tchamyou, Venessa, 2016. "Information Asymmetry and Financial Dollarization in Sub-Saharan Africa," MPRA Paper 77310, University Library of Munich, Germany.
    4. Joshua Aizenman & Brian Pinto, 2004. "Managing Volatility and Crises: A Practitioner's Guide Overview," NBER Working Papers 10602, National Bureau of Economic Research, Inc.
    5. Togo, Eriko, 2007. "Coordinating public debt management with fiscal and monetary policies : an analytical framework," Policy Research Working Paper Series 4369, The World Bank.
    6. Sven Steinkamp & Frank Westermann, 2012. "On Creditor Seniority and Sovereign Bond Prices in Europe," CESifo Working Paper Series 3944, CESifo Group Munich.
    7. Michael G. Papaioannou, 2009. "Exchange Rate Risk Measurement and Management: Issues and Approaches for Public Debt Managers," South-Eastern Europe Journal of Economics, Association of Economic Universities of South and Eastern Europe and the Black Sea Region, vol. 7(1), pages 7-34.
    8. Raheem, Ibrahim D. & Asongu, Simplice A., 2016. "Extending the Determinants of Dollarization in Sub-Saharan Africa: The Role of Easy Access to Foreign Exchange Earnings," MPRA Paper 75415, University Library of Munich, Germany.
    9. Andrew J Swiston, 2011. "Official Dollarization As a Monetary Regime; Its Effectson El Salvador," IMF Working Papers 11/129, International Monetary Fund.
    10. Gill, Indermit & Pinto, Brian, 2005. "Public debt in developing countries : has the market-based model worked?," Policy Research Working Paper Series 3674, The World Bank.
    11. Gulati, Mitu & Zettelmeyer, Jeromin, 2012. "Making a Voluntary Greek Debt Exchange Work," CEPR Discussion Papers 8754, C.E.P.R. Discussion Papers.

    More about this item

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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