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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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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Morris, S & Song Shin, H, 1996. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks," Economics Papers 126, Economics Group, Nuffield College, University of Oxford.
  2. Leonardo Martinez & Cesar Sosa Padilla & Juan Hatchondo, 2012. "Debt dilution and sovereign default risk," 2012 Meeting Papers 974, Society for Economic Dynamics.
  3. 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.
  4. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
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  7. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, number 8973, 06-2016.
  8. 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.
  9. 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.
  10. Cesar Sosa-Padilla, 2014. "Sovereign Defaults and Banking Crises," 2014 Meeting Papers 666, Society for Economic Dynamics.
  11. Juan Carlos Conesa & Timothy J. Kehoe, 2014. "Is It Too Late to Bail Out the Troubled Countries in the Eurozone?," NBER Working Papers 19909, National Bureau of Economic Research, Inc.
  12. Timothy J. Kehoe & Edward C. Prescott(), 2007. "Great depressions of the twentieth century," Monograph, Federal Reserve Bank of Minneapolis, number 2007gdott.
  13. Cristina Arellano & Juan Carlos Conesa & Timothy J. Kehoe, 2012. "Chronic sovereign debt crises in the Eurozone, 2010-2012," Economic Policy Paper 12-4, Federal Reserve Bank of Minneapolis.
  14. Reinhart, Karmen & Rogoff, Kenneth, 2009. ""This time is different": panorama of eight centuries of financial crises," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 1, pages 77-114, March.
  15. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  16. 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.
  17. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
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  19. Timothy Kehoe & Edward Prescott, 2002. "Data Appendix to Great Depressions of the Twentieth Century," Technical Appendices kehoe02, Review of Economic Dynamics.
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