In this paper, I use a two-country model to investigate the incentives which lead one country to take charge of another country's debt. I show that, when direct transfers to residents cannot be perfectly targeted, the first country can be better honoring the second country's liabilities, even if this means paying foreign creditors. Anticipating the ex post rescue, private agents engage in a collective bet on the foreign country's debt, leading to the emergence of a self-fulfilling implicit guarantees in equilibrium. In response to the resulting inefficient outcome, the optimal policy for the rescuing country's government is to restrict domestic exposures to foreign debt ex ante, for example, through a tax on capital outflows. Finally, I argue that these findings can shed light on the European sovereign debt crisis, the interventions of the IMF, the 1790 US federal bailout of states and on the 2008 US financial crisis.
Classification JEL : F33, F34, F36, F42, F65.
Keywords : Implicit guarantees, bailouts, capital flows, capital controls.
Updated on: 04/24/2019 09:05