(Job Market Paper)
The ongoing European debt crisis highlights the role of coordination problems and self-fulfilling beliefs as drivers of sovereign default risk. Typically, this role has been formalised in models with multiple equilibria, inhibiting policy analysis. In this paper, I employ global-game techniques to induce a unique equilibrium. Along the unique equilibrium, I show how the equilibrium default risk can be decomposed in a solvency-risk component and a coordination-risk component. I then study how fiscal policy can be effective in managing the coordination risk and characterise how the shape of the optimal policy is affected by the presence of this risk. I finally show that making the deficit contingent on interest rate movements is more effective in managing default risk than non-contingent fiscal targets.
“Public Information Manipulation and Sovereign Default Risk”
(with Emine Boz)
Misreporting of public debt and deficit data is an important phenomenon affecting sovereign default risk. In this paper, we study the problem of a government with access to a costly technology to manipulate an exogenous public signal about economic fundamentals. Lenders process the potentially contaminated public signal as well as their private signals and an endogenous public signal conveyed by the bond price to decide whether to lend or not. Lenders do not observe the degree of manipulation. However, they hold rational expectations, so as they process the public signal, they account for the government’s incentives to manipulate.