DP15781 Self-inflicted debt crises
Optimal resolution of debt crises requires bailouts to account for borrowers' time-inconsistency. We show in a dynamic model of strategic default that myopic borrowers undervalue their option to default by a U-shaped error, which causes excessive leverage, imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether financial transfers exacerbate or alleviate the borrowers' misperception of default risk. The model shows that borrowers and lenders ultimately self-inflict debt crises through their strategic interaction, myopic distress can be cheaper to resolve than rational distress, and myopia can benefit stakeholders.