Gambling for Redemption and Self-Fulfilling Debt Crises

Abstract

We develop a model of the sorts of sovereign debt crisis that have occurred recently in such European countries as Greece, Ireland, and Portugal. The government sets its expenditure-debt policy optimally given a fixed probability of a recovery in fiscal revenues. In doing so, the government can optimally choose to “gamble for redemption,” and the economy can be optimally driven to a level of debt with increased vulnerability to self-fulfilling debt crisis. The model explains why, in contrast to the Mexican crisis of 1994–95, where a loan package put together by U.S. President Bill Clinton put an immediate end to the crisis, rescue packages put together by the European Union do not seem to have helped Greece, Ireland, or Portugal.