Gambling for redemption and self-fulfilling debt crises
Juan Carlos Conesa () and
Timothy Kehoe ()
No 465, Staff Report from Federal Reserve Bank of Minneapolis
We develop a model for analyzing the sovereign debt crises of 2010–2012 in the Eurozone. The government sets its expenditure-debt policy optimally. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfilling crises in which investors, anticipating a crisis, are unwilling to buy the bonds, thereby provoking the crisis. In this situation, the optimal policy of the government is to reduce its debt to a level where crises are not possible. If, however, the economy is in a recession where there is a positive probability of recovery in fiscal revenues, the government may optimally choose to “gamble for redemption,” running deficits and increasing its debt, thereby increasing its vulnerability to crises.
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Working Paper: Gambling for Redemption and Self-Fulfilling Debt Crises (2012)
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