DP12921 The Dynamics of Sovereign Debt Crises and Bailouts

Author(s): Francisco Roch, Harald Uhlig
Publication Date: May 2018
Keyword(s): Bailouts, default, Endogenous Borrowing Constraints, Eurozone Debt Crisis, long-term debt, OMT, Self-fulfilling Crises
JEL(s): F34, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12921

Motivated by the recent European debt crisis, this paper investigates the scope for a bailout guarantee in a sovereign debt crisis. Defaults may arise from negative income shocks, government impatience or a "sunspot"-coordinated buyers strike. We introduce a bailout agency, and characterize the strategy with the minimal actuarially fair intervention which guarantees the no-buyers-strike fundamental equilibrium, relying on the market for residual financing. The intervention makes it cheaper for governments to borrow, inducing them borrow more, leaving default probabilities possibly rather unchanged. The maximal backstop will be pulled precisely when fundamentals worsen.