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

32 Pages Posted: 14 Sep 2002 Last revised: 13 Aug 2022

See all articles by Joshua Aizenman

Joshua Aizenman

University of Southern California - Department of Economics

Kenneth M. Kletzer

University of California at Santa Cruz; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Brian Pinto

Independent

Date Written: September 2002

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

Aizenman, Joshua and Kletzer, Kenneth M. and Pinto, Brian, Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don't Avert Macroeconomic Crises (September 2002). NBER Working Paper No. w9190, Available at SSRN: https://ssrn.com/abstract=330329

Joshua Aizenman (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

Kenneth M. Kletzer

University of California at Santa Cruz ( email )

Santa Cruz, CA 95064
United States
(408) 459-3407 (Phone)
(408) 459-5000 (Fax)

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Brian Pinto

Independent ( email )

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