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.
Meeting
ID: 869 8191
1369
Passcode:
166986
