Uncertainty Shocks and Non-Fundamental Debt Crises: An Ambiguity Approach

Abstract

This paper develops a theory of sovereign debt crises driven by uncertainty shocks that are modeled as changes in investors' confidence in the macroeconomic fundamental of the economy. Due to defaultable government debt, uncertainty feeds into investors' beliefs about the fiscal sustainability of public debt. The inherent indeterminacy is resolved using maxmin preferences in view of ambiguity averse investors. An uncertainty shock raises the price of issuing debt which in turn affects the optimal tax and borrowing decision of the government. Within a critical zone of indebtedness, uncertainty shocks may lead to non-fundamental default events which share important features and partly endogenize sun-spot driven self-fulfilling crises. The quantitative effects of the mechanism are explored using an estimated business cycle model where a bank-sovereign nexus propagates uncertainty shocks to the macro economy. Forecasters' disagreement is used to identify the non-fundamental share of sovereign yields. The model attributes a sizeable share of sovereign yields to time-variation in uncertainty. Other model predictions are shown to be consistent with impulse responses obtained from a VAR analysis for a panel of Euro area countries.