Sovereign debt spread and default in a model with self-fulfilling prophecies and asymmetric information
Abstract
The euro area sovereign debt crisis has renewed interest in government credibility and the
risk of default. Recent empirical evidence has shown that the sharp increase in government
bond yields cannot be attributed entirely to changes in macroeconomic fundamentals. Contagion
effects can occur, and self-fulfilling speculation may arise. In this paper, we develop
a theoretical model in the spirit of the second-generation currency crisis models developed
by Obstfled (1996). The model describes a strategic game between governments and private
investors. Euro area countries face a trade-off as governments may either commit to and implement
restrictive fiscal policies or default on debt. The commitment strategy may not be
optimal if the fundamentals deteriorate. The policy maker lose part of their credibility, and
governments are forced to default. In addition, we introduce uncertainty about the cost of default
in the model, which is then able to account for a greater variety of equilibrium. Thus,
when the evaluation of the cost of default is asymmetric, prophecies are not always realized
and default does not occur. Simulations of the model then show that it offers insights, and can
help to account for the situations of Greece and Italy during the sovereign debt crisis.