Allison Bertelson/Minneapolis Fed
In recent decades, industrialized nations have often chastised developing countries for their difficulties in dealing with sovereign debt (bonds sold by governments on international markets to pay for national needs). Debt crises in Argentina, Mexico, and elsewhere in Latin America, and later in Southeast Asia, prompted accusations of irresponsible fiscal and monetary policies and resulted in International Monetary Fund bailouts, with stringent conditions attached.
But current events reveal that developed nations are far from immune from sovereign debt calamities. Following the Great Recession, several eurozone nations faced debt crises that threatened the stability and survival of the European Monetary Union.
This is the context for Mark Aguiar and Manuel Amador’s Minneapolis Fed staff report on “Self-Fulfilling Debt Dilution” (SR565), in which the economists analyze the problem of nations that address their inability to repay debt on bonds they’ve sold by selling still more bonds—thereby diluting the value of earlier bonds, to the detriment of the lender who bought them.
To understand this remarkably complex issue, the economists must modify the standard sovereign debt model and search for an equilibrium. They find several—multiple equilibria with very different debt outcomes—but focus on two, one with high levels of borrowing, and its opposite: high saving and no debt. Whether an economy shifts toward one equilibrium or the other, the economists discover, depends on lender expectations. And, curiously, this result means that a common policy prescription for the disease of debt dilution may instead lead directly to it.
A complex analysis
Economists have long recognized that sovereign debt crises can be self-fulfilling. If lenders believe that nations are likely to default, they’ll charge them higher interest rates—just as a bank will set a higher rate for a less creditworthy borrower. But the higher rate makes it more difficult for nations to repay. “If you believe I’m going to default, you’ll charge me high interest rates,” says Amador, explaining a borrower’s decision-making. “That weakens my incentive to pay you back, and I may end up defaulting. That’s the self-fulfilling aspect in sovereign debt models: Because you think I am going to default, then I behave in a way that confirms this belief.”
When this plays out over time, nations in debt trouble are prone to borrow more rather than paying off existing debt, and this dynamic debt dilution adds layers of difficulty in determining its endpoint. Standard models are too intractable—mathematically complex and unwieldy—to use successfully with the intricacies of self-fulling dilution.
Aguiar and Amador overcome that intractability, creating a usable version of the benchmark sovereign debt model. They then use their enhanced model to analyze self-fulfilling debt dilution and find that under very realistic assumptions about government borrowing preferences and costs of bond default, there is no single answer to whether nations will or won’t default in a given situation.
The self-fulfilling expectations of creditors create a feedback loop. “Creditor expectations of future borrowing and default behavior determine bond prices today,” the economists write. “In turn, current and anticipated bond prices affect the government’s incentives to borrow.” A key feature of the loop, says Amador, is that debt is “somewhat long term: intermediate. Creditors are not pricing what governments are doing today; they’re also worried about what governments will do in the future.”
This loop between creditors and borrowers (investors and governments) can stop at many possible outcomes—multiple equilibria with markedly different debt responses. The economists focus on a borrowing equilibrium and a saving equilibrium. The latter is preferred: The government reduces its debt until default is no longer possible. The borrowing equilibrium is the “bad” outcome: The government continually borrows until it no longer needs external funds (but racks up massive debt).
Save or spend?
In both equilibria, the government weighs its preference to borrow to finance current consumption (compared with the market’s preference—“relative impatience”) against the costs of default, such as lost credit reputation, exclusion from international debt markets, trade penalties, and even asset seizure. And the outcome depends on what lenders believe about the borrower’s tendency. “Whether relative impatience or deadweight costs of default are the dominant force,” write Aguiar and Amador, “depends on creditor beliefs.”
If a creditor believes that a government will, in fact, implement fiscal reforms to diminish unnecessary spending or increase taxes, it is likely to raise the price it will offer for a government’s bonds, lowering the burden of debt financing and enabling the government to achieve the good “saving equilibrium.”
But if the creditor feels the opposite, expecting that a government will continue to spend excessively and not raise sufficient revenue, the creditor will anticipate default on prior bonds, lower the price it offers for that government’s future bonds, and thereby bring about the very outcome it feared: debt dilution.
A “solution” that isn’t
The economists use this framework to analyze policy responses and determine that the oft-proposed policy of price floors would not only fail, in all likelihood, but might actually lead to debt dilution. To achieve the saving equilibrium, governments must face a price penalty for increasing the probability of default. A price support could undermine that discipline. A better solution, theoretically, would be a firm debt limit. But recent experience in the eurozone suggests that such debt limits are hard to enforce and lack credibility.