Crises Beyond Belief: Findings on Contagion, the Role of Beliefs, and the Eurozone Debt Crisis from a Borrower–Lender Game

Jonathan W. Welburn ()
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Jonathan W. Welburn: RAND Corporation

Computational Economics, 2020, vol. 56, issue 2, No 1, 263-317

Abstract: Abstract The 1997 Asian financial crisis, the 1998 Russian crisis, the 2007 global financial crisis, and the 2009 Eurozone crisis redrew the landscape of economic risk. Each crisis elucidated the systemic nature of economic risk, where adverse events appear increasingly capable of quickly spreading from one country to the next through a process commonly known as contagion. This paper presents a borrower–lender game with sequential moves and imperfect information, to discuss the potential for contagion through debt and trade channels while highlighting the role of beliefs. While many in the literature focus on contagion as a direct transmission of economic shocks through debt and trade channels, this paper finds that contagion through trade is unlikely and that the role of lender beliefs can result in apparent contagion. The paper presents new theory, computational solutions, extensive sensitivity analysis, and a case study of the Eurozone crisis. Results demonstrate that changes in lender beliefs following revelations of a crisis in one country may lead a lender to be unwilling to lend to another country. This in turn may create a self-fulfilling prophecy where, without access to credit, that country may be less willing and able to repay past debts. Furthermore, results demonstrate that the borrower–lender game in this paper can explain apparent contagion throughout the Eurozone crisis through deteriorating lender beliefs. While the conventional story is that contagion leads to real propagations through debt (or trade), we find that a real propagation of shocks is not needed.

Keywords: Contagion; Sovereign debt; Default crisis; Game theory; Imperfect information; Beliefs; Bayesian updating; Sensitivity analysis; European Union; Eurozone crisis; Country risk (search for similar items in EconPapers)
JEL-codes: C6 C7 G01 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1007/s10614-019-09926-7

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