Self-fulfilling debt crises, fiscal policy and investment

Carlo Galli

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I consider a sovereign default model with fiscal policy and private capital accumulation. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. In the bad equilibrium, pessimistic beliefs make sovereign debt costly. The government substitutes borrowing with taxation, which depresses private investment and future output, increases default probabilities and verifies lenders’ beliefs. This result is reminiscent of the European debt crisis of 2010-12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis.

Keywords: Self-fulfilling debt crises; sovereign default; multiple equilibria; fiscal austerity (search for similar items in EconPapers)
JEL-codes: E44 E62 F34 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2019-02-21
New Economics Papers: this item is included in nep-dge, nep-mac and nep-opm
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http://eprints.lse.ac.uk/100942/ Open access version. (application/pdf)

Related works:
Journal Article: Self-fulfilling debt crises, fiscal policy and investment (2021)
Working Paper: Self-Fulfilling Debt Crises, Fiscal Policy and Investment (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:100942

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