Dynamic Panics: Theory and Application to the Eurozone

Stangebye, Zachary (2015): Dynamic Panics: Theory and Application to the Eurozone.

Abstract

It is shown in a standard quantitative model of sovereign debt and default that sentiment shocks can alter the distribution of fundamental defaults. The channel through which this occurs is a new type of dynamic lender coordination problem in sovereign debt markets that I call a dynamic panic. During a dynamic panic of this kind, expectations of future negative investor sentiments dilute the price of long-term debt; the sovereign's optimal response to such a panic can be to borrow aggressively, which justifies investors' fears of dilution. Such panics generate naturally many of the unique features the recent Eurozone crisis, and so I explore policy implications in this environment. I find that rate ceilings are an ineffective policy tool but that liquidity provision, appropriately implemented, can eliminate such panics.

• Item Type: MPRA Paper
• Language: English
• Keywords: Sovereign Debt Crises, Confidence-Driven Crises, Long-Term Debt
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems; G - Financial Economics > G0 - General > G01 - Financial Crises; H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt ; Debt Management ; Sovereign Debt

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