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Learning about Debt Crises

Radek Paluszynski

No 1602, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: The European debt crisis of 2008-2014 was marked with a surge in government bond yields on unprecedented scale among developed countries in modern history. The peak of this crisis occurred with a significant lag following the initial shocks to output, even though governments did not undertake the fiscal adjustments necessary to prevent a further increase in default risk. I show that these observations are at odds with the predictions of existing sovereign debt models and propose a new theory that features disaster risk and incomplete information about the country’s economic outlook. In a model calibrated to Portuguese economy, the delay arises endogenously as a result of the markets’ learning process. I support the theory with a dataset of real-time forecasts (private and public) and show that forecast errors were particularly large at the outset of the Great Recession, in line with the model predictions.

Date: 2017
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