Self-inflicted debt crises

Schürhoff, Norman and Theodosios Sakis Dimopoulos
Authors registered in the RePEc Author Service: Norman Schuerhoff

No 15781, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Optimal resolution of debt crises requires bailouts to account for borrowers' time-inconsistency. We show in a dynamic model of strategic default that myopic borrowers undervalue their option to default by a U-shaped error, which causes excessive leverage, imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether financial transfers exacerbate or alleviate the borrowers' misperception of default risk. The model shows that borrowers and lenders ultimately self-inflict debt crises through their strategic interaction, myopic distress can be cheaper to resolve than rational distress, and myopia can benefit stakeholders.

Keywords: Borrower myopia; Time-inconsistency; Strategic default; Debt crisis; Bailout fund; Real options (search for similar items in EconPapers)
JEL-codes: D86 G01 G4 H63 (search for similar items in EconPapers)
Date: 2021-02
New Economics Papers: this item is included in nep-fdg
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Working Paper: Self-inflicted Debt Crises (2021)
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