TY - JOUR AU - Aizenman,Joshua AU - Kletzer,Kenneth M. AU - Pinto,Brian TI - Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps Don't Avert Macroeconomic Crises JF - National Bureau of Economic Research Working Paper Series VL - No. 9190 PY - 2002 Y2 - September 2002 UR - http://www.nber.org/papers/w9190 L1 - http://www.nber.org/papers/w9190.pdf N1 - Author contact info: Joshua Aizenman Department of Economics; E2 1156 High St. University of California, Santa Cruz Santa Cruz, CA 95064 Tel: 831/459-4791 Fax: 831/459-5077 E-Mail: jaizen@ucsc.edu Kenneth Kletzer University of California, Santa Cruz Department of Economics 217 Social Sciences 1 Santa Cruz, CA 95064 Tel: 408-459-3407 E-Mail: kkletzer@cats.ucsc.edu Brian Pinto MSN MC4-406 The World Bank, 1818 H Street NW Washington DC 20433 E-Mail: bpinto2@worldbank.org AB - This paper argues that the frequent failure of the debt swaps is not an accident. Instead, it follows from fundamental forces driven by the market's assessment of the scarcity of fiscal revenue relative to the demand for fiscal outlays. It follows from the observation that arbitrage forces systematically impact prices in asset markets. Ignoring these price adjustments would lead to too optimistic an assessment of the gains from swaps or buybacks. A by-product of our paper is to highlight the perils of financial engineering that ignores the intertemporal constraints imposed by fiscal fundamentals. As a country approaches the range of partial default (either on domestic or external debt), swaps may not provide the expected breathing room and could even bring the crisis forward. Our methodology combines three independent themes: exchange rate crises as the manifestation of excessive monetary injections [Krugman-Flood-Garber], the fiscal theory of inflation [Sargent-Wallace (1981)], and sovereign debt. The integrated framework derives devaluation and external debt repudiation as part of a public-finance optimizing problem. We shows that under conditions similar to those which prevailed in Russia and Argentina prior to their meltdown, swaps are not just neutral, but could actually make the situation worse and even trigger a speculative attack. An unsettlingly clear implication of the model is that there may be very few options left once public debt reaches levels regarded as unsustainable in relation to fiscal fundamentals. Dollarization only makes matters worse, and pushes the debt write-down option to the fore. ER -