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Sovereign Bailouts and Moral Hazard with Strategic Default

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

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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.

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