Sovereign Bailouts and Moral Hazard with Strategic Default

Perazzi, Elena (2020): Sovereign Bailouts and Moral Hazard with Strategic Default.

Abstract

A recent reform of the European Stability Mechanism (ESM) renews some classical questions about bailouts. Why should bailouts create moral hazard, when they do not involve any debt relief? What is the rationale for ex-ante fiscal conditions? I address these questions in a model of strategic default, in which a debt crisis occurs after a bad fundamental shock. The market's willingness to lend is limited by the inability of the government to commit to future repayment. An International Financial Institution (IFI) is able to enforce repayment, and can bail out the government by lending more than the markets are willing to do. But, with the IFI ready to step in, markets change their behavior and are willing to lend more, and the government reacts by accumulating more debt. In a numerical analysis calibrated to Argentina, I show that, although the incidence of default is reduced thanks to the IFI, bailouts are frequent and inevitable unless bailout access is subject to conditionality.

• Item Type: MPRA Paper
• Language: English
• Keywords: Strategic Default, Bailouts, Conditionality, Moral Hazard
• Subjects: H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents; H - Public Economics > H6 - National Budget, Deficit, and Debt

References

Aguiar, Mark, and Gita Gopinath (2006), "Defaultable debt, interest rates and the current account", Journal of international Economics 69.1: 64-83.

Arellano, Cristina (2008), "Default risk and income fluctuations in emerging economies", American Economic Review 98.3: 690-712.

Aylward, Lynn, and Rupert Thorne (1998), "Countries' Repayment Performance Vis-a-Vis the IMF: An Empirical Analysis", IMF Staff Papers 45.4: 595-618.

Carré, Sylvain, Daniel Cohen, and Sébastien Villemot (2019), "The sources of sovereign risk: a calibration based on Lévy stochastic processes", Journal of International Economics 118: 31-43.

Cole, Harold L., and Timothy J. Kehoe (2000), "Self-fulfilling debt crises", The Review of Economic Studies 67, no. 1: 91-116.

Collard, Fabrice, Michel Habib, and Jean-Charles Rochet (2015), "Sovereign debt sustainability in advanced economies", Journal of the European economic association 13.3: 381-420.

Corsetti, Giancarlo, Aitor Erce, and Timothy Uy (2018), "Debt sustainability and the terms of official support".

Corsetti, Giancarlo, Bernardo Guimaraes, and Nouriel Roubini (2006), "International lending of last resort and moral hazard: A model of IMF's catalytic finance", Journal of Monetary Economics 53.3: 441-471.

Cuadra, Gabriel, Juan M. Sanchez, and Horacio Sapriza (2010), "Fiscal policy and default risk in emerging markets", Review of Economic Dynamics 13.2: 452-469.

Fink, Fabian, and Almuth Scholl (2016), "A quantitative model of sovereign debt, bailouts and conditionality", Journal of International Economics 98: 176-190.

Galli, Giampaolo (2020), "The reform of the ESM and why it is so controversial in Italy", Capital Markets Law Journal 15.3: 262-276.

Ghosh, A. R., Kim, J. I., Mendoza, E. G., Ostry, J. D. and Qureshi, M. S. (2013), "Fiscal fatigue, fiscal space and debt sustainability in advanced economies", The Economic Journal, 123(566), F4-F30.

Greenwood, Jeremy, Zvi Hercowitz, and Gregory W. Huffman (1988), "Investment, capacity utilization, and the real business cycle", The American Economic Review: 402-417.

Roch, Francisco, and Harald Uhlig (2018), "The dynamics of sovereign debt crises and bailouts", Journal of International Economics 114: 1-13.

Rogoff, Kenneth S. (2002), "Moral hazard in IMF loans: how big a concern?", Finance and Development 39.3 (2002): 56-57

Stokey, Nancy L., Robert E. Lucas Jr. and Edward C. Prescott (1989), "Recursive methods in economic dynamics", Harvard University Press.

Trabandt, Mathias, and Harald Uhlig (2012), "How do Laffer curves differ across countries?". No. w17862, National Bureau of Economic Research.

Zettelmeyer, Jeromin, Jonathan David Ostry, and Olivier Jeanne (2008), "A theory of international crisis lending and IMF conditionality" (2008), No. 8-236. International Monetary Fund.