Working Paper: CEPR ID: DP15781
Authors: Theodosios Sakis Dimopoulos; Norman Schurhoff
Abstract: 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.
Keywords: borrower myopia; time-inconsistency; strategic default; debt crisis; bailout fund; real options
JEL Codes: H63; G01; G4; D86
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| borrower myopia (G51) | undervaluation of option to default (G33) |
| undervaluation of option to default (G33) | excessive leverage (G32) |
| undervaluation of option to default (G33) | underinvestment (G31) |
| borrower myopia (G51) | debt crises (F34) |
| optimal bailouts (H81) | influence on timing of defaults (G33) |
| optimal bailouts (H81) | influence on duration of crises (F44) |
| myopic distress (E71) | cheaper resolution than rational distress (G33) |
| interaction between myopic borrowers and rational lenders (G21) | self-inflicted debt crisis (F34) |
| myopic borrowers and rational lenders (G21) | escalation of crisis (H12) |