EconPapers    
Economics at your fingertips  
 

Self-fulfilling debt crises, fiscal policy and investment

Carlo Galli

Journal 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)
JEL-codes: E44 E62 F34 G12 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0022199621000520
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

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 Rodríguez-Clare, Andrés

More articles in Journal of International Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().

 
Page updated 2021-07-24
Handle: RePEc:eee:inecon:v:131:y:2021:i:c:s0022199621000520