Theo Dimopoulos (HEC Lausanne) (webinar)
12 May 2021 @ 12:00 - 13:15
“Self Inflicted Debt Crises”
Abstract: The restrictions on economic activity in the Covid-19 pandemic have led to a looming debt crisis. In a dynamic model of strategic default and debt renegotiation, we show how to resolve debt crises depending on borrowers’ time-inconsistent preferences. Myopic borrowers misprice their option to default by a U-shaped negative pricing error, which causes imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. The model shows that bailouts need to be tailored to borrowers’ myopia, that lenders and borrowers ultimately self-inflict debt crises through their strategic interaction, that myopic distress can be cheaper to resolve than rational distress, and that myopia can be beneficial for rational agents. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether transfers exacerbate or alleviate the borrowers’ misperception of default risk.