Preventing Self-Fulfilling Crises

This paper develops a model of self-fulfilling debt crises and uses it to study the effectiveness of various government policies in preventing such crises. In the model, a crisis is a result of the interaction between bad fundamentals and self-fulfilling expectations of domestic firms and lenders. I solve the model using the global games approach and analyze policy proposals directed at preventing debt crises, such as, an increase in taxes, spending cuts and fiscal stimulus. I explain the costs and benefits associated with each policy, provide conditions under which these policies decrease or increase probability of default, and investigate their welfare implications. I find that tax increase or spending cuts tend to decrease the likelihood of crisis but may result in lower welfare. On the other hand, a well-timed fiscal stimulus can improve welfare, but it tends to increase the probability of a crisis. The above conclusions depend crucially on the timing and credibility of the government's policies, as well as on the initial state of the economy.