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Self-inflicted debt crises

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  • Schürhoff, Norman
  • Dimopoulos, Theodosios Sakis

Abstract

Optimal resolution of debt crises requires bailouts to account for borrowers' time-inconsistency. We show in a dynamic model of strategic default that myopic borrowers undervalue their option to default by a U-shaped error, which causes excessive leverage, imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether financial transfers exacerbate or alleviate the borrowers' misperception of default risk. The model shows that borrowers and lenders ultimately self-inflict debt crises through their strategic interaction, myopic distress can be cheaper to resolve than rational distress, and myopia can benefit stakeholders.

Suggested Citation

  • Schürhoff, Norman & Dimopoulos, Theodosios Sakis, 2021. "Self-inflicted debt crises," CEPR Discussion Papers 15781, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:15781
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    More about this item

    Keywords

    Borrower myopia; Time-inconsistency; Strategic default; Debt crisis; Bailout fund; Real options;
    All these keywords.

    JEL classification:

    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • G01 - Financial Economics - - General - - - Financial Crises
    • G4 - Financial Economics - - Behavioral Finance
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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