Why Do Countries in Financial Distress Strategically Delay Seeking Help?

Abstract

The paper differs from current literature by providing a systematic analysis of the relationship between sovereign debt, financial distress and political career concerns via a novel game-theoretic model, in order to analyze the strategic behavior of governments in revealing financial distress and requesting a rescue program from international organizations. The analysis shows that, in equilibrium, a rent-seeking government will "gamble for resurrection" by strategically delaying the revelation of financial distress through the creation of "hidden debt," hoping that things will improve in the future which will enable getting away with hiding the unfavorable news. This is so when the electorate only has short-term commitment power, if the government expects sufficient rents, provided a re-elected government adds to national output through experience, or international rescue organizations charge a relatively low interest rate, or the electorate discounts the future sufficiently. The analysis discusses incentive systems, such as differential interest rates when the government has been caught cheating, credit limiting and austerity, that can deter strategic delays, and a precommitment mechanism to get around time inconsistency.

Keywords: Asymmetric Information, Financial Distress, Sovereign Debt.

JEL Classification: D82, D83, D84, D72, D73, F34, G01, H63.