Why is Confidence in Sovereign Debt Fickle?

Abstract

One of the main conclusions of Reinhart and Rogoff’s study of sovereign debt crises, highlighted in its title This Time is Different, is that markets for sovereign debt are prone to manic mood swings. When things go well for an extended period, lenders tend to underestimate risks of crisis. They are too short-sighted even to anticipate their own vulnerability to self-fulfilling panic. This paper shows that rational learning about unstable risks can explain most of these phenomena, even when perceptions don’t affect the underlying default risks. Between the relative infrequency of default and the small number of relevant comparators, sovereign debt markets are bound to make rational learners unusually sensitive to recent news. The resulting “rational myopia” makes both confidence and lack of confidence fickle. This can be useful from a policy perspective since it speeds recovery after crisis. However, one bad surprise can deflate it. Simulations show striking understatement of risk on the eve of default. Hence our analysis supports Reinhart and Rogoff’s warning (2009, xxv) that “excessive debt accumulation […] often poses greater system risks than it seems during a boom”. Indeed, it implicitly calls for extra vigilance by policymakers, to help check what lenders almost surely won’t.