Debt Crises, Fast and Slow

Drawing on the theory of sovereign risk, we show that, driven by self-fulfilling expectations of default, both slow-moving and rollover (fast) crises are generically possible in models with standard features, at intermediate and high levels of debt, respectively. This is without relying on the specification of debt auctions by Cole and Kehoe (2000). A necessary condition is that debt tolerance thresholds—the time- and state- contingent levels of debt above which default becomes the preferred action by the government—respond endogenously to shifts in investors' expectations. In a sunspot equilibrium, the threat of belief-driven crises may not be enough for the government to deleverage in a recession, and bring debt to default-free levels. Unless the initial debt is close enough to the critical threshold above which the country becomes vulnerable to such crises, the government will keep borrowing, gambling on economic recovery in the future