Re-examining the Roles of Beliefs and Information in Sovereign Debt Crises

University Of Pennsylvania, Philadelphia PA

Investigators

Abstract

This award funds research on sovereign debt crises. This type of crisis occurs when there is a large increase in the prices of a country's sovereign bonds compared to low-risk or risk-free bonds. The Greek debt crisis is a recent example. This research project seeks to determine if changes in beliefs and information acquisition by investors can explain some key observed features of these crises. First, that these crises seem to come and go without much warning and with only a loose connection to country-level fundamentals. Second, that they also exhibit contagion - that is, they spread from one country to the next. The first part of the project considers whether crises may turn on relatively minor pieces of information. The second part examines the role of information in debt crises by modeling how investors make decisions about whether or not to gather additional information before bidding on government bonds. The project develops basic insights that can aid U.S. policymakers in determining the correct responses to sovereign debt crises outside the United States, as well as helping policymakers around the world avoid these crises altogether. The first project funded by this award considers the full set of equilibria in models of self-fulfilling crisis models along the lines of Cole and Kehoe (2000). The goal is to demonstrate that one equilibrium in these models has not been recognized by previous research. That equilibrium is consistent with the data in two different ways: first, a crisis can occur without a fail auction leading to default. Second, sovereign spreads are not tightly linked to country fundamentals. The second project continues with this model but adds an information choice decision for investors and carefully models the sort of trading gains investors can expect to accrue based on information. The project will then analyze the model to determine if equilibria with and without information acquisition can simultaneously exist and to characterize the equilibrium results.