Preventing Self-fulfilling debt crises

This paper asks whether a government can implement policies that help to avert a crisis driven by self-fulfilling expectations. I consider two policies that are often at the center of political discussions, namely austerity and fiscal stimulus. I find that under plausible conditions austerity tends to decrease the probability of a debt crisis, while stimulus tends to increase it. I also show that endogenous expectations amplify the effects of government policies so that even a small policy adjustment can have significant effects. Finally, I find that policy uncertainty further increases the attractiveness of austerity versus stimulus, but tends to decrease the overall impact of both policies.