Fragile Debt and the Credible Sharing of Strategic Uncertainty
NBER Working Paper No. 18377
This paper studies debt fragility. It provides conditions under which fundamentals and strategic uncertainty jointly determine the price of sovereign debt. Default arises in equilibrium both because of fundamental shocks and beliefs. The probability of default depends on borrowing rates and, in equilibrium, on the beliefs of lenders about this probability. This interaction creates a strategic complementarity and thus the basis for strategic uncertainty. The paper analyzes the role of debt guarantees as a means of sharing both fundamental and strategic uncertainty. It provides conditions for the credibility of those guarantees as well as ex post bailouts. The effects of debt purchases by a monetary authority are analyzed as well.
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