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Sovereign Risk under Diagnostic Expectations

Author

Listed:
  • Stefan Niemann

    (University of Konstanz)

  • Timm M. Prein

    (University of Helsinki Graduate School of Economics)

Abstract

This paper studies the consequences of overreaction to news in the context of a quantitative model of sovereign debt and default. Overreaction is formalized in terms of diagnostic expectations that excessively extrapolate from current condi-tions. Examining historical IMF growth forecasts, we find empirical evidence for this behavior and incorporate it into an otherwise standard model of long-term sovereign debt. The model successfully matches salient business cycle statistics, including the distribution of sovereign spreads, and also predicts an empirically plausible default frequency. Counterfactual experiments indicate that diagnostic expectations induce sizeable welfare losses, the bulk of which could be eliminated under rational behavior of the sovereign borrower. Fiscal rules, which restrict bor-rower behavior via limits on admissible levels of debt or spreads, can therefore be used in a welfare-enhancing way. Although spread-brake rules may be subject to distortions from diagnostic market sentiment, they o˙er robustness and generally perform better than debt-brake rules.

Suggested Citation

  • Stefan Niemann & Timm M. Prein, 2025. "Sovereign Risk under Diagnostic Expectations," Working Paper Series of the Department of Economics, University of Konstanz 2025-02, Department of Economics, University of Konstanz.
    • Handle: RePEc:knz:dpteco:2502
    as

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    File URL: http://www.uni-konstanz.de/FuF/wiwi/workingpaperseries/WP_02_Niemann_Prein_2025.pdf
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    References listed on IDEAS

    as
    1. Juan Carlos Hatchondo & Leonardo Martinez & Francisco Roch, 2022. "Fiscal Rules and the Sovereign Default Premium," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(4), pages 244-273, October.
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    More about this item

    Keywords

    sovereign debt; diagnostic expectations; fiscal rules;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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