Working Paper: NBER ID: w19228
Authors: Guido Lorenzoni; Ivan Werning
Abstract: What circumstances or policies leave sovereign borrowers at the mercy of self-fulfilling increases in interest rates? To answer this question, we study the dynamics of debt and interest rates in a model where default is driven by insolvency. Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise. We show that low and high interest rate equilibria may coexist. Higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. We call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default. We investigate how the existence of multiple equilibria is affected by the fiscal policy rule, the maturity of debt, and the level of debt.
Keywords: sovereign debt; self-fulfilling crises; interest rates
JEL Codes: E63; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher interest rates (E43) | faster debt accumulation (G51) |
| faster debt accumulation (G51) | validates default fears (C52) |
| validates default fears (C52) | creates self-fulfilling crisis (H12) |
| higher interest rates (E43) | creates feedback loop (E10) |
| state of the economy (E66) | influences bond prices (E43) |
| bond prices (G12) | affects government's ability to finance obligations (E62) |
| low and high interest rate equilibria (E43) | coexist due to dynamics of fiscal deficits and surpluses (H62) |
| short-term debt (H63) | more susceptible to self-fulfilling crises (E71) |
| high interest rate equilibrium (E43) | can emerge as slow moving crisis (H12) |
| credible announcement (Y60) | rules out bad equilibria (D50) |