 Self-fulfilling debt crises, fiscal policy and investmentJournal of International Economics, 2021, vol. 131, issue C Abstract: This paper studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I consider a sovereign default model with fiscal policy and private capital accumulation. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. In the bad equilibrium, pessimistic beliefs make sovereign debt costly. The government substitutes borrowing with taxation, which depresses private investment and future output, increases default probabilities and verifies lenders' beliefs. This result is reminiscent of the European debt crisis of 2010–12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis. The extent of this type of crises can be reduced by the intervention of an external official lender committing to provide liquidity, or by policies aimed at sustaining private investment. Keywords: Self-fulfilling debt crises; Sovereign default; Multiple equilibria; Fiscal austerity (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:131:y:2021:i:c:s0022199621000520 DOI: 10.1016/j.jinteco.2021.103475 Access Statistics for this article Journal of International Economics is currently edited by Gourinchas, Pierre-Olivier and RodrÃguez-Clare, Andrés More articles in Journal of International Economics from Elsevier |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
EconPapers is hosted by the
School of Business at Örebro University.