Self-fulfilling Crises Research Articles

Sovereign debt markets in turbulent times: Creditor discrimination and crowding-out effects

In 2007, countries in the euro zone periphery were enjoying stable growth, low deficits, and low spreads. Then the financial crisis erupted and pushed them into deep recessions, raising their deficits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private sector to the public sector, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowding-out effects can be transmitted to other countries in the euro zone, and how they may be addressed by policies at the European level.

Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out Effects

In 2007, countries in the Euro periphery were enjoying stable growth, low deficits, and low spreads. Then the financial crisis erupted and pushed them into deep recessions, raising their deficits and debt levels. By 2010,they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sectors, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: credit or discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowding-out effects can be transmitted to other countries in the Eurozone, and how they may be addressed by policies at the European level.

Accounting for Crises

We provide one of the first empirical evidence consistent with recent macro global-game crisis models, which show that the precision of public signals can coordinate crises (e.g., Angeletos and Werning 2006; Morris and Shin 2002, 2003). In these models, self-fulfilling crises (independent of poor fundamentals) can occur only when publicly disclosed signals of fundamentals have high precision; poor fundamentals are the sole driver of crises only in low precision settings. We find evidence consistent with this proposition for 68 currency and systemic banking crises in 17 countries from 1983-2005. We exploit a key publicly-disclosed signal of fundamentals that drives financial markets, namely accounting data, and find that pre-crisis accounting signals of fundamentals are significantly lower only in low precision countries.

Revenge of the Optimum Currency Area

Revenge of the Optimum Currency Area

Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out

In 2007, countries in the Euro periphery were enjoying stable growth, low deficits, and low spreads. Then the financial crisis erupted and pushed them into deep recessions, raising their deficits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sectors, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowding-out effects can be transmitted to other countries in the Eurozone, and how they may be addressed by policies at the European level.

FIRE for the Euro: A Superior Way to Bond Market Stabilization

Summary Government bond markets within the euro zone may have fallen victim to a self-fulfilling crisis of confidence. Eurobonds may contribute to stabilization in the short-run but would imply destructive disincentives and incalculable risks for joint and several guarantors. Monetary interest rate equalization through the ECB government bond purchase program poses risks for central bank credibility and price stability. This contribution proposes fiscal interest rate equalization (FIRE) as an alternative. With FIRE, countries that benefit from low interest rates as a consequence of market panics would transfers some of their savings to subsidize the borrowing of crisis countries within a conditional fiscal scheme. The paper presents FIRE’s principles and discusses its advantages over alternative stabilization approaches. Furthermore, a simulation of a FIRE specification is presented which would shield Italy and Spain against interest rates above 5 percent.

Self-fulfilling crises in the Eurozone: An empirical test

We test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We find evidence that a significant part of the surge in the spreads of the peripheral Eurozone countries during 2010–11 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, and was associated with negative self-fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the Eurozone into bad equilibria. We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries.

Flexibility: Stability's Best Friend in Non-transparent Countries?

This paper proposes a framework for studying the optimal exchange rate regime in an open economy vulnerable to self-fulfilling currency crises. Model results show that the optimal regime a country's government should adopt critically depends on the country's level of transparency. Furthermore, stabilisation properties are conditional on conjectural and time-varying factors such as market sentiments, which swing according to international investors’ feelings. Thus, and paradoxically, in a weakly transparent economy, greater flexibility gives rise to a wide range of exchange-rate stability compared with hard-anchoring regimes. Key to this is the role of expectations coordination during stressful scenarios.

Credibilidade e crises cambiais: uma aplicação do modelo de Velasco (Credibility and Currency Crises: Empirical Evidence of Velasco's Model)

This paper analyzes the currency crises of the South American countries during the period from 1992 to 1998, based on the Velasco (1996) model. This is a model that synthesizes two approaches: speculative attacks resulting from unbalanced macroeconomics fundamentals and resulting from self-fulfilling prophecies, even when the economies show good fundamentals. Nine Latin American countries are classified by means of a loss function index. Thus, it is possible to classify the countries by the degree of vulnerability to the crises, establishing zones of credibility. The results indicate that the Brazilian economy, since it shows problems in its macroeconomic fundamentals, was classified in the zone of null credibility. Argentina moves from a zone of high credibility to an intermediate or partial zone. This is an indication that Argentina became susceptible to self-fulfilling crises. All other countries were classified in the zone of high credibility.

Die Europäische Schuldenkrise: Ursachen und Lösungsstrategien

Summary This contribution highlights the complex causes of the European debt crisis and discusses available options for a solution. Relevant causes included are debt incentives which are effective permanently, the lacking optimality of the European currency area and deficient institutional debt brakes. Furthermore, the acute dimension of the crisis as a self-fulfilling crisis of confidence with a highly destructive potential is stressed. All solution strategies face the challenge that a self-fulfilling confidence crisis cannot be contained through an improvement of long-run fundamentals alone. Based on this analysis the crisis management is assessed. One insight is that the often criticized cautious and muddling-through approach towards a permanent solution is adequate. In contrast to that, allegedly courageous solutions like the introduction of eurobonds or the quick exclusion of crisis countries from the euro zone are unconvincing. Links to the economic literature of the early 1990s prove that the risk of a debt crisis has clearly been identified and analyzed as a particular risk of the European Monetary Union well before its start.

Self-fulfilling crises with default and devaluation

We characterize optimal debt policy in a dynamic stochastic general equilibrium model of defaults and devaluations in which self-fulfilling crises can arise. When the government cannot commit to repay its debt and cannot commit to maintain the exchange rate, consumers’ expectations of devaluation make the safe level of government debt very low. We show that, when the debt is in the crises zone—where self-fulfilling crisis can occur—the government finds it optimal to reduce the debt to exit the zone. The lower the probability that consumers assign to devaluation, however, the greater is the number of periods that the government will choose to take to exit the crisis zone. We argue that our model can help understand events in Argentina in 2001–2002 and throw light on some aspects of the current EMU sovereign debt crisis.

Self-Fulfilling Crises in the Eurozone: An Empirical Test

We test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We find evidence that a significant part of the surge in the spreads of the PIGS countries in the Eurozone during 2010-11 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, and was the result of negative self-fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the Eurozone into bad equilibria. We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries.

Intertwined Sovereign and Bank Solvencies in a Model of Self-Fulfilling Crisis

Large fiscal financing needs, both in advanced and emerging market economies, have often been met by borrowing heavily from domestic banks. As public debt approached sustainability limits in a number of countries, however, high bank exposure to sovereign risk created a fragile inter-dependence between fiscal and bank solvency. This paper presents a simple model of twin (sovereign and banking) crisis that stresses how this interdependence creates conditions conducive to a self-fulfilling crisis.

Self-Fulfilling Crises in the Eurozone: An Empirical Test

We test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We find evidence that a significant part of the surge in the spreads of the PIGS countries in the Eurozone during 2010-11 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, and was the result of negative self-fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the Eurozone into bad equilibria. We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries.

Intertwined Sovereign and Bank Solvencies in a Model of Self-Fulfilling Crisis

Large fiscal financing needs, both in advanced and emerging market economies, have often been met by borrowing heavily from domestic banks. As public debt approached sustainability limits in a number of countries, however, high bank exposure to sovereign risk created a fragile inter-dependence between fiscal and bank solvency. This paper presents a simple model of twin (sovereign and banking) crisis that stresses how this interdependence creates conditions conducive to a self-fulfilling crisis.

Bubbles and Self-Fulfilling Crises

Financial crises are often associated with an endogenous credit reversal followed by a fall in asset prices and serious disruptions in the financial sector. To account for this sequence of events, this paper constructs a model where excessive risk-taking by investors leads to a bubble in asset prices, and where the supply of credit to these investors is endogenous. We show that the interplay between excessive risk-taking and the endogeneity of credit may give rise to multiple equilibria associated with different levels of lending, asset prices, and output. Stochastic equilibria lead, with positive probability, to an inefficient liquidity dry-up, a market crash, and widespread failures by borrowers. The possibility of multiple equilibria and self-fulfilling crises is shown to be related to the severity of the risk-shifting problem in the economy.

Self-Fulfilling Currency Crises with Borrowing Constraints and Domestic Currency Debt

This paper presents a model of self-fulfilling currency crises in economies that do not suffer from domestic liability dollarization but whose international borrowing is subject to a collateral constraint. The model shows that when the collateral is a non-traded asset the expectation of a real exchange rate depreciation may trigger the constraint and cause a crisis in which the capital outflow and the real depreciation reinforce each other. Since in the model debt is denominated in domestic currency this paper highlights that borrowing constraints can cause self-fulfilling currency crises even in the absence of foreign-currency debt.

Predatory Short-Selling and Self-fulfilling Crises: When Morris-Shin Meets Diamond-Dybvig

This paper investigates the mechanism through which short selling of a bank's stocks can trigger the failure of the bank. In the model, creditors, who learn information from stock prices, will grow increasingly unsure about the bank's true fundamentals in facing noisier stock prices; thus a run on the bank is more likely because of creditors' concave payoff. Understanding this, speculators conduct short selling beforehand to amplify (il)liquidity and add noise to stock prices, triggering a bank run, and subsequently profit from the bank's failure. We show that short-selling attacks on a bank involve two runs: the aggressive run among speculators and the conservative run among creditors. These two runs interact and reinforce each other, with compound feedback loops that drastically increase the probability of the collapse of the bank. We discuss policy implications of the model.

Fiscal Trends and Self-Fulfilling Crises

This paper develops a second-generation currency crisis model with endogenously changing fundamentals. Previous second-generation models are static, e.g. Obstfeld (1994), or dynamic with exogenous paths of fundamentals, e.g. Obstfeld (1986). In our model, the government weighs the disutility of making fundamentals consistent with a peg against a penalty for floating. If the former dominates, the government runs expansionary policies, precipitating a crisis. For some parameters, self-fulfilling speculation affects when the crisis happens, but not whether it happens. For other values, there are “purely self-fulfilling” crises, where a peg that could have survived forever collapses if attacked in the first few periods.

Accounting for Crises

We provide among the first empirical evidence, consistent with recent macro global game crisis models, that shows that the precision of public signals can coordinate crises. In these models, self-fulfilling crises independent of fundamentals can occur only when publicly disclosed signals of fundamentals have high precision; poor fundamentals are the sole driver of crises only in low precision settings. We exploit a key publicly disclosed signal of fundamentals, namely accounting data, for 68 currency and systemic banking crises in 17 countries. We find that precrisis accounting signals of fundamentals are significantly lower only in low-precision countries. (JEL D82, E44, G01, G14, G21 L25, M40)