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  3. American Economic Review
  4. September 2020
  5. Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models

Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models

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Abstract

We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional "lender of last resort" policies.

Citation

Aguiar, Mark, and Manuel Amador. 2020. "Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models." American Economic Review, 110 (9): 2783-2818. DOI: 10.1257/aer.20180831

Additional Materials

JEL Classification

  • E44 Financial Markets and the Macroeconomy
  • E62 Fiscal Policy
  • F34 International Lending and Debt Problems
  • G12 Equities; Fixed Income Securities
  • H63 National Debt; Debt Management; Sovereign Debt