Self-Fulfilling Debt Crises, Revisited

We revisit self-fulfilling rollover crises by exploring the potential uncertainty introduced by a gap (however small) between an auction of new debt and the payment of maturing liabilities. It is well known (Cole and Kehoe, 2000) that the lack of commitment at the time of auction to repayment of imminently maturing debt can generate a run on debt, leading to a failed auction and immediate default. We show the same lack of commitment leads to a rich set of possible self-fulfilling crises, including a government that issues more debt because of the crisis, albeit at depressed prices. Another possible outcome is a "sudden stop" (or forced austerity) in which the government sharply curtails debt issuance. Both outcomes stem from the government's incentive to eliminate uncertainty about imminent payments at the time of auction by altering the level of debt issuance. An interesting aspect of the novel crisis equilibria is that the government always transacts at prices associated with the most optimistic beliefs. That is, beliefs induce the government to change debt issuances to a level at which prices are invariant to beliefs, even if this means a sharp reduction or increase in equilibrium issuances relative to the best-case scenario. The distortion of debt policy generates a large increase in spread volatility in both a one-period and multi-period quantitative debt model.