The Dynamics of Sovereign Debt Crises and Bailouts
42 Pages Posted: 10 May 2018
Date Written: May 10, 2018
Motivated by the recent European debt crisis, this paper investigates the scope for a bailout guarantee in a sovereign debt crisis. Defaults may arise from negative income shocks, government impatience or a "sunspot"-coordinated buyers strike. We introduce a bailout agency, and characterize the strategy with the minimal actuarially fair intervention which guarantees the no-buyers-strike fundamental equilibrium, relying on the market for residual financing. The intervention makes it cheaper for governments to borrow, inducing them borrow more, leaving default probabilities possibly rather unchanged. The maximal backstop will be pulled precisely when fundamentals worsen.
Keywords: Default, Bailouts, Self-fulfilling Crises, Endogenous Borrowing Constraints, Long-term Debt, OMT, Eurozone Debt Crisis
JEL Classification: F34, F41
Suggested Citation: Suggested Citation