Gambling for Redemption and Self-fulfilling Debt Crises

The Monetary and Fiscal History of Latin America: Gambling for Redemption and Self-fulfilling Debt Crises

Drawing parallels from fiscal crises in Mexico, Timothy Kehoe presents model for analyzing the sovereign debt crises of 2010–2012 in the Eurozone. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfil...

Summary

Drawing parallels from fiscal crises in Mexico, Timothy Kehoe presents model for analyzing the sovereign debt crises of 2010–2012 in the Eurozone. The need to sell large quantities of bonds every period leaves the government vulnerable to self-fulfilling crises in which investors, anticipating a crisis, are unwilling to buy the bonds, thereby provoking the crisis. The optimal policy is to reduce debt to a level where crises are not possible, unless the nation is in a recession. In that case, with potential of future increase in revenues, the government may optimally choose to “gamble for redemption,” running deficits and increasing its debt, but also increasing its vulnerability to crises.