Can Debt Crises Be Self-Fulfilling?

IMF Working Papers, June 1, 2004

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Several papers argue that debt crises can be the result of self-fulfilling expectations that no one will lend to a country.
The author shows that this type of coordination failure can be eliminated by:
- a combination of state-contingent securities, and
- a mechanism that allows investors to promise to lend only if enough other investors do so as well.
This suggests that runs on the debt of a single borrower (such as the government) can be eliminated.
The paper also concludes that self-fulfilling features are more plausible when articulated in a context in which externalities among many decentralized borrowers allow for economy-wide debt runs to occur.

Coordination failures leading to debt crises can be addressed through financial design:
- State-contingent securities provide payoffs that depend on realized states, which can align incentives across states of the world.
- Promise-to-lend mechanisms conditional on sufficient participation can prevent unilateral withdrawal that triggers a run.
Debt runs on a single borrower can be eliminated under the proposed combination of instruments and mechanisms.
Self-fulfilling crisis narratives gain plausibility in settings with many decentralized borrowers generating externalities that permit economy-wide debt runs.

Author: Marcos Chamon
Date: June 1, 2004
Series: Working Paper No. 2004/099
Issue: 099
Volume: 2004
Pages: 21
Stock No: WPIEA0992004
ISBN: 9781451852301
ISSN: 1018-5941
Note: Disclaimer — This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Source: IMF Working Papers — "Can Debt Crises Be Self-Fulfilling?", Marcos Chamon, Working Paper No. 2004/099, June 1, 2004.