Research

This paper studies the consequences of overreaction to news in a quantitative model of sovereign debt and default. Overreaction is formalized in terms of diagnostic expectations that excessively extrapolate from current conditions. We build on survey evidence showing extrapolation in financial analysts’ country growth forecasts to determine the degree of diagnostic behavior in our model. We find that diagnostic expectations amplify perceived downside risk, depress bond prices globally, and produce systematic forecast errors that translate into borrower welfare losses and creditor gains. Pricing and welfare effects depend critically on whether diagnostic behavior arises on the borrower or creditor side, with borrower-side distortions accounting for most sovereign welfare losses. Diagnostic distortions also have implications for the design of fiscal rules: Optimal debt limits tighten under diagnostic borrowing, whereas optimal spread-based rules need to accommodate sentiment-driven mispricing. Binding rules reallocate part of the surplus created by lending from creditors to the borrower.

After 2008, the Southern European economies suffered a strong and persistent increase in unemployment. Rising government bond spreads necessitated the implementation of austerity policies. Austerity, however, may increase unemployment. If workers lose human capital during unemployment spells, the economy’s future production potential and thus the fiscal capacities to serve public debt will decline, aggravating a sovereign debt crisis. Haircuts can help to avoid the costs of austerity. I introduce skill loss during unemployment in a dynamic stochastic model of sovereign debt with long-term debt and labor market frictions to study optimal fiscal policy in sovereign debt crises. In a quantitative exercise, I find that with higher intensity of the skill loss, ex ante, fiscal policy becomes less pro-cyclical and unemployment less volatile. During crises, early haircuts are associated with the largest short-term welfare gains and the strongest short-run and medium-run unemployment reductions.

This paper develops a stochastic dynamic politico-economic model of sovereign debt to analyze the impact of bailouts on political turnover and sovereign default risk. We consider a small open economy in which the government has access to official loans conditional on the implementation of austerity policies. There is a two-party system in which both parties care about the population’s welfare but differ in an exogenous utility cost of default. Political turnover is the endogenous outcome of the individual voting behavior. In a quantitative application to the Greek economy, we find that bailouts amplify political turnover risk, which, in turn, elevates sovereign interest spreads. While stricter conditionality fosters the probability of political turnover and sovereign default in the short run, it may mitigate political turnover and default risk in the long run. The frequency of political turnover is U-shaped in the strength of conditionality.