Repeated Bailouts and Austerity

Abstract

This paper studies the incidence of bailouts with the possibility that bailouts may be required repeatedly before the crisis is resolved. I build a model in which two countries engage in a strategic interaction over repeated bailouts and austerity. The strategic interaction ends when the country in crisis has either overcome the crisis or defaulted. Evaluating the properties of the Markov-equilibrium of the model, I show how the rescuing country trades off the costs of bailout with the spillover costs from default. I find that the fundamental conflict of interest over austerity arises over the speed of repayment of the failing country's debt. This finding suggests a new definition for austerity that distinguishes between a solvency and a liquidity dimension of a sovereign debt crisis.

Keywords: Bailouts, Austerity, Sovereign Debt

JEL Classification: E00, E6, F3, G15