Working Paper: CEPR ID: DP6718
Authors: Daniel Cohen; Sébastien Villemot
Abstract: We distinguish two attitudes towards debt. The attitude of prudent borrowers, which attempt to stabilize their debts to low levels, even in the event of a bad shock, and what we call, after Krugman, "Panglossian" borrowers, which only focus on the best of their growth prospects, and rationally anticipate to default on their debt when hit by a bad shock. We show empirically that this distinction is consistent with the data. Past a threshold of risk which, we show, corresponds to a spread of about 450 basis points, countries fail to respond to bad shocks and let their risk drift accordingly. We also distinguish two types of debt crises. Those which are the effect of an exogenous shock, and those which are self-fulfillingly created by the financial markets themselves. We show that the large majority of crises are of the first kind, although the probability of self-fulfilling cases is not negligible.
Keywords: self-fulfilling crises; sovereign debt
JEL Codes: F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prudent borrower behavior (G51) | stabilization of debt ratios after bad shocks (F65) |
| panglossian borrower behavior (G51) | increase in debt ratios after bad shocks (F65) |
| debt-to-GDP ratio (H68) | likelihood of debt crisis (F34) |
| real income per capita (E25) | likelihood of debt crisis (F34) |
| currency overvaluation (F31) | likelihood of debt crisis (F34) |
| exogenous shocks (F41) | majority of debt crises (F34) |
| lack of confidence in debt servicing (F34) | capital flight and subsequent default (F32) |
| debt crises (F34) | self-fulfilling characteristics (D84) |