Crises Beyond Belief: Findings on Contagion, the Role of Beliefs, and the Eurozone Debt Crisis from a Borrower–Lender Game
- 5 Downloads
The 1997 Asian financial crisis, the 1998 Russian crisis, the 2007 global financial crisis, and the 2009 Eurozone crisis redrew the landscape of economic risk. Each crisis elucidated the systemic nature of economic risk, where adverse events appear increasingly capable of quickly spreading from one country to the next through a process commonly known as contagion. This paper presents a borrower–lender game with sequential moves and imperfect information, to discuss the potential for contagion through debt and trade channels while highlighting the role of beliefs. While many in the literature focus on contagion as a direct transmission of economic shocks through debt and trade channels, this paper finds that contagion through trade is unlikely and that the role of lender beliefs can result in apparent contagion. The paper presents new theory, computational solutions, extensive sensitivity analysis, and a case study of the Eurozone crisis. Results demonstrate that changes in lender beliefs following revelations of a crisis in one country may lead a lender to be unwilling to lend to another country. This in turn may create a self-fulfilling prophecy where, without access to credit, that country may be less willing and able to repay past debts. Furthermore, results demonstrate that the borrower–lender game in this paper can explain apparent contagion throughout the Eurozone crisis through deteriorating lender beliefs. While the conventional story is that contagion leads to real propagations through debt (or trade), we find that a real propagation of shocks is not needed.
KeywordsContagion Sovereign debt Default crisis Game theory Imperfect information Beliefs Bayesian updating Sensitivity analysis European Union Eurozone crisis Country risk
JEL ClassificationC6 C7 G01
This paper has been made possible by several amazing people and organizations. First and foremost, I am grateful for the enduring advice of Vicki N. Bier without which this work could not have been completed. I am also grateful for the advice of Oguzhan Alagoz, Menzie Chinn, Kjell Hausken, and Thomas Rutherford and helpful feedback each provided. Additionally, I am thankful for the research assistance of Anne Velazquez and Victor Rodriguez. This work was supported by the National Science Foundation under Grant No. DGE-1256259, the University of Wisconsin-Madison College of Engineering. I am thankful to the University of Wisconsin-Madison, where the majority of this work was done, and my current employer, the RAND Corporation, for its support.
- Acemoglu, D., Ozdaglar, A., & Tahbaz-Salehi, A. (2013). Systemic risk and stability in financial networks. National Bureau of Economic Research Working Paper Series, No. 18727. https://doi.org/10.3386/w18727.
- Arellano, C., & Bai, Y. (2013). Linkages across sovereign debt markets. National Bureau of Economic Research Working Paper Series, No. 19548. https://doi.org/10.3386/w19548
- Bloomberg, L. P. (2016). Credit default swap prices 12/1/2010 to 12/31/2011. Retrieved 1 July 2016 from Bloomberg database.Google Scholar
- Chan-Lau, J. A. (2006). Market-based estimation of default probabilities and its application to financial market surveillance (EPub). Washington: International Monetary Fund.Google Scholar
- Chen, Z., Huang, W., & Zheng, H. (2017). Estimating heterogeneous agents behavior in a two-market financial system. Journal of Economic Interaction and Coordination, 13, 1–20.Google Scholar
- Forbes, K., & Rigobon, R. (2000). Contagion in Latin America: Definitions, measurement, and policy implications. National Bureau of Economic Research Working Paper Series, No. 7885. https://doi.org/10.3386/w7885
- FRED. (2016). Federal reserve economic data. Retrieved 6/29/2016, from Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/.
- Goldstein, M. (1998). The Asian financial crisis: Causes, cures, and systemic implications. Washington: Peterson Institute.Google Scholar
- Kaminsky, G. L., Reinhart, C., & Vegh, C. A. (2003). The unholy trinity of financial contagion. National Bureau of Economic Research Working Paper Series, No. 10061. https://doi.org/10.3386/w10061.
- Kiyotaki, N., & Moore, J. (1995). Credit cycles. National Bureau of Economic Research Working Paper Series, No. 5083. https://doi.org/10.3386/w5083.
- Lorenzoni, G., & Werning, I. (2013). Slow moving debt crises. National Bureau of Economic Research Working Paper Series, No. 19228. https://doi.org/10.3386/w19228.
- Mendoza, E. G., & Yue, V. Z. (2011). A general equilibrium model of sovereign default and business cycles. National Bureau of Economic Research Working Paper Series, No. 17151. https://doi.org/10.3386/w17151.
- Morris, S., & Shin, H. (2000). Global games: Theory and applications. New Haven: Cowles Foundation for Research in Economics.Google Scholar
- Morris, S., & Shin, H. (2012). Contagious adverse selection. American Economic Journal: Macroeconomics, 4(1), 1–21.Google Scholar
- Obstfeld, M. (1984). Rational and Self-fulfilling balance-of-payments crises. National Bureau of Economic Research Working Paper Series, No. 1486. https://doi.org/10.3386/w1486
- Reinhart, C. M., & Rogoff, K. S. (2008). This time is different: A panoramic view of eight centuries of financial crises. National Bureau of Economic Research Working Paper Series, No. 13882. https://doi.org/10.3386/w13882
- World Bank. (2016). Total population statistics. Retrieved 15 Nov 2016 http://data.worldbank.org/indicator/SP.POP.TOTL?locations=GR.