The roots of self-fulfilling debt crises by Bruno Sultanum

Join us for this weeks Macroeconomics Research Seminar, Spring Term 2024.

Bruno Sultanum, from the Federal Reserve Bank of Richmond, will present this weeks Macroeconomics seminar on The roots of self-fulfilling debt crises.

Abstract

Self-fulfilling crises are a defining feature of sovereign debt markets. We show that a self-fulfilling crisis equilibrium creates an arbitrage opportunity. When agents beliefs’ can support both default and repayment, under the default equilibrium, lenders with sufficient resources can bid the debt up to the fundamental equilibrium price—triggering repayment and a gain for debt holders. We study the roots of self-fulfilling debt crises based on this arbitrage opportunity.

We start with a two-period model. In this case, without limits to arbitrage due to resource constraints, (i) a unique equilibrium survives, and (ii) in the unique equilibrium there is no default due to rollover risk. Self-fulfilling debt crises arise again when resource constraints are tight. In three or more periods, self-fulfilling crises can also arise due to a hold-up problem that reduces investors participation in bond auctions. This hold up problem is, in part, the consequence of an imperfect secondary market for sovereign bonds. Empirically, we find that in larger countries default risk is more volatile and less well explained by fundamental variables, in line with our model’s predictions.

This seminar will be held on campus in the Economics Common Room at 1.30pm on Tuesday 12th March 2024. This event is open to all levels of study and is also open to the public. To register your place, please contact the seminar organisers.

This event is part of the Macroeconomics Research Seminar Series.