Self-inflicted Debt Crises

Theodosios Dimopoulos and Norman Schürhoff
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Theodosios Dimopoulos: University of Lausanne - School of Economics and Business Administration (HEC-Lausanne); Swiss Finance Institute
Norman Schürhoff: University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)
Authors registered in the RePEc Author Service: Norman Schuerhoff

No 21-11, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: In a dynamic model of optimal bailouts, we show how borrower myopia affects the severity of debt crises. Myopic borrowers misprice the option to default with a U-shaped negative pricing error. The myopia discount changes the optimal bailout policy. Myopia gets punished when the distortions from default mispricing outweigh the future bailout costs, resulting in procrastinated default and protracted crises. The model shows that (i) myopia is an important determinant for bailout policy, (ii) myopic default can be cheaper to resolve than rational default, (iii) rational agents can benefit from a myopic sovereign borrower, and (iv) credit spread dynamics are more asymmetric under myopia than rationality, consistent with empirical evidence.

Pages: 69 pages
Date: 2021-02
New Economics Papers: this item is included in nep-dge and nep-fdg
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Related works:
Working Paper: Self-inflicted debt crises (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2111

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