Sovereign Risk under Diagnostic Expectations

Stefan Niemann and Timm Marc Prein

No 2025-02, Working Paper Series of the Department of Economics, University of Konstanz from Department of Economics, University of Konstanz

Abstract: This paper studies the consequences of overreaction to news in the context of a quantitative model of sovereign debt and default. Overreaction is formalized in terms of diagnostic expectations that excessively extrapolate from current condi-tions. Examining historical IMF growth forecasts, we find empirical evidence for this behavior and incorporate it into an otherwise standard model of long-term sovereign debt. The model successfully matches salient business cycle statistics, including the distribution of sovereign spreads, and also predicts an empirically plausible default frequency. Counterfactual experiments indicate that diagnostic expectations induce sizeable welfare losses, the bulk of which could be eliminated under rational behavior of the sovereign borrower. Fiscal rules, which restrict bor-rower behavior via limits on admissible levels of debt or spreads, can therefore be used in a welfare-enhancing way. Although spread-brake rules may be subject to distortions from diagnostic market sentiment, they o˙er robustness and generally perform better than debt-brake rules.

Keywords: sovereign debt; diagnostic expectations; fiscal rules (search for similar items in EconPapers)
JEL-codes: E44 E62 F34 H63 (search for similar items in EconPapers)
Date: 2025-02-04
New Economics Papers: this item is included in nep-dge and nep-opm
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Working Paper: Sovereign Risk under Diagnostic Expectations (2024)
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