Slow Moving Debt Crises

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.

4 Responses to Slow Moving Debt Crises

  1. Anonymous says:

    This is a rather “mechanical” environment in that spending is exogenous and default only happens when it’s the only feasible option, never strategically. These features are a substantial step backwards compared to the state-of-the-art sovereign default literature.

  2. M.H. says:

    Without having read the paper: it looks like this paper want to take expectation formation and how it impacts interest rates seriously. If this is at the expense of endogenous spending, is this necessarily a step backwards?

  3. Anonymous (Same as ^) says:

    > “it looks like this paper want to take expectation formation and how it impacts interest rates seriously”

    This is perhaps an overstatement. The paper follows the literature in assuming that “there is a group of wealthy risk-neutral investors that compete in the credit market and ensure that the equilibrium price of a short term debt equals [q = \beta (conditional probability of default at t+1)]” (page 6).

    There is a sense in which the paper leans heavily on the (well understood?) idea that default depends on the terms of borrowing and the terms of borrowing depend on the expectation of default. Expectations are thoroughly standard too.

    Presumably it is an empirical question (to some extent) whether government spending and borrowing behavior is better understood in terms of a parsimonious rule or as a maximizing agent; or whether default is strategic, i.e. mainly a function of the willingness rather than the ability to repay.

  4. Anonymous says:

    By the way, the paper’s findings are not new:

    Bi (EER, 2012) and Bi/Traum (AER, 2012) show that such an ability-to-repay approach to sovereign default can deliver plausible quantitative predictions.

    Jussen/Linnemann/Schabert (2012) show that there are two possible equilibria, just as in Lorenzoni/Werning’s paper.

    None of those papers are mentioned in the paper though…

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