Beliefs and long-maturity sovereign debt

A novel form of strategic complementarities is explored in a standard quantitative model of long-maturity sovereign debt. Discrepancies in long-run beliefs dilute current prices differently. Negative long-run beliefs become self-fulfilling if the sovereign optimally borrows more and defaults more frequently in the face of worse prices. A strong curvature in the flow utility is an important ingredient in generating this response. The intuition bears out both through a multiplicity of Markov equilibria and in sunspot equilibria that mimic trigger strategies in repeated games. In the benchmark model, average spreads are roughly 67% higher (200 basis points) and debt-to-GDP ratios are roughly 9% higher (5 percentage points) when beliefs are pessimistic. The model also reveals limitations to third-party coordination of expectations as a policy tool.