Debt Crises: For Whom the Bell Tolls

Harold Cole, Daniel Neuhann, Guillermo Ordoñez

NBER Working Paper No. 22330
Issued in June 2016
 

What a country has done in the past, and what other countries are doing in the present, can feedback for good or for ill in debt markets. We develop a simple model of sovereign bond markets with global investors and endogenous information acquisition about fundamental default probabilities. This model displays hysteresis and contagion in sovereign bond spreads. Small fundamental shocks in one country can induce investors to acquire information, generating price volatility and increased risk premia. These changes may also induce investors to rebalance their portfolio, generating market segmentation and information acquisition in seemingly unrelated economies. Information regimes may persist over time, requiring large improvements in fundamentals to return to more stable bond spread conditions.