By Guido Lorenzoni and Ivan Werning
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.
The debt crisis in Europe looks like a long freight train that takes a very long time to garner speed, and to break. This is part of what this paper is trying to understand, contrasting this with other crises that happen suddenly and quickly. This one is different because of feedback rules that amplify initial shocks, but slowly and without creating an immediate expectation that the path is irremediably unsustainable, as government commitment is imperfect. Another interesting outcome is that there is multiplicity of equilibria from a Laffer curve effect of interest rates on public debt. With high interests rates, debt increases faster, generating more default fears and again higher interest rates. With low interest rates, they tend to remain that way as less debt is accumulated.