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Gambling for Redemption and Self-Fulfilling Debt Crises

  • Timothy Kehoe

    (University of Minnesota)

  • Juan Carlos Conesa

    (Universitat Autonoma de Barcelona)

We develop a model for analyzing the sovereign debt crises of 2010 and 2011 in such European countries as Greece, Ireland, and Portugal. The government sets its expenditure-debt policy optimally given a fixed probability of a recovery in fiscal revenues. In doing so, the government can optimally choose to “gamble for redemption,†and the economy can be optimally driven to a level of debt that increases its vulnerability to self-fulfilling debt crises. The model explains why, in contrast to the Mexican crisis of 1994–95, where a loan package put together by U.S. President Bill Clinton put an immediate end to the crisis, rescue packages put together by the European Union do not seem to have ended the crises in Greece, Ireland, or Portugal.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 614.

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Date of creation: 2012
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Handle: RePEc:red:sed012:614
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  1. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  2. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "Debt dilution and sovereign default risk," Working Paper 10-08, Federal Reserve Bank of Richmond.
  3. Fernando Broner & Guido Lorenzoni & Sergio L. Schmukler, 2011. "Why Do Emerging Economies Borrow Short Term?," Working Papers 308, Barcelona Graduate School of Economics.
  4. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
  5. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187 - 232.
  6. Mark Aguiar & Gita Gopinath, 2004. "Defaultable Debt, Interest Rates and the Current Account," NBER Working Papers 10731, National Bureau of Economic Research, Inc.
  7. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  8. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  9. Guido Lorenzoni & Ivan Werning, 2013. "Slow Moving Debt Crises," NBER Working Papers 19228, National Bureau of Economic Research, Inc.
  10. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  11. Cesar Sosa-Padilla, 2014. "Sovereign Defaults and Banking Crises," 2014 Meeting Papers 666, Society for Economic Dynamics.
  12. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  13. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  14. Chamley Christophe P & Pinto Brian, 2011. "Why Official Bailouts Tend Not To Work: An Example Motivated by Greece 2010," The Economists' Voice, De Gruyter, vol. 8(1), pages 1-5, February.
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