Self-Fulfilling Debt Crises

TLDR

The study aims to identify the debt levels and maturity structures that trigger confidence‑based financial crises and to delineate the government's optimal policy response within a dynamic, stochastic general equilibrium framework. A dynamic, stochastic general equilibrium model is used to analyze how debt values and maturity structures influence the likelihood of confidence‑driven crises. When fundamentals lie within the crisis zone, the government can exit the crisis by reducing debt, which induces an economic boom and lowers interest rates, and this reduction may be gradual if debt is high or crisis probability low, while extending maturity shrinks the crisis zone but credibility‑inducing policies can produce perverse effects.

Abstract

We characterize the values of government debt and the debt's maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the country's fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the government's debt. We show that this reduction can be gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.