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Several papers argue that debt crises can be the result of self-fulfilling expectations that no one will lend to a country, triggering default and rationalizing the refusal to lend. I show these coordination failures can be eliminated by a combination of state-contingent securities and a mechanism that allows investors to promise to lend only if enough other investors do so as well. This suggests that runs on the debt of a single borrower (such as the government) can be eliminated and that self-fulfilling features are more plausible when externalities among many decentralized borrowers allow for economy-wide debt runs to occur.

The concept of a “solvent but illiquid” debtor has frequently been used to explain debt crises. In these models, a borrowing country is willing to repay its debts provided it can spread repayments over time by issuing new debt in order to roll over part of the debt coming due. However, if the country is unable to issue new debt, it is assumed to either be forced to default for not being able to repay the debt out of its current output or to find it optimal to default, because repaying the debt would leave very little for current consumption. Such seemingly arbitrary loss of access to credit can be the result of a self-fulfilling creditor panic even if all agents are rational. This view has become one of the dominant frameworks used to discuss alternative policies and crisis prevention measures. This paper shows that this type of self-fulfilling feature often articulated in the debt crises literature can in theory be eliminated by simple market mechanisms of voluntary participation. The argument that self-fulfilling expectations can trigger runs on the short-term debt of a country that are analogous to a Diamond and Dybvig (1983) bank run was first formally articulated by Sachs (1984). Cole and Kehoe, 1996 and Cole and Kehoe, 2000 present a much richer model, where the coordination failure is not limited to existing creditors and involves new potential lenders as well. They show that, if every investor expects other investors not to lend to the country and if that would trigger default, then no individual investor would be willing to lend new funds, self-fulfilling their expectations. I show that, if this is the only reason investors are unwilling to lend, the coordination failure can be overcome by offering the new debt through a mechanism where investors are allowed to condition their participation on a large enough amount being successfully issued. The borrowing country can then choose any outcome for that issue provided it satisfies the participation constraints laid out by the investors in their contingent bids. Since every investor is willing to lend provided the others do so as well, the country is always able to select the “good equilibrium”. Similar procedures are observed in practice for different types of financial intermediation. For example, when underwriting a bond issue, an investment bank guarantees its size, holding whatever amount it cannot find a buyer for. A very similar mechanism to the one proposed is used by some start-up firms to raise funds. Investors often commit to providing a share of the amount that needs to be raised by the start-up firm, provided the remaining part can be raised from other investors at similar terms. Sovereign debt exchanges, which take place following a default or as an attempt to prevent one, may also include features that condition the outcome on the overall participation. For example, completion of a debt exchange may be tied to the achievement of a given participation level.1 That way, participants know that they will only exchange their old bonds for the new ones if enough other bondholders do the same (non-participation in a successful exchange may lead to losses depending on how hold-outs are treated).2 The repayment of today's investors may also depend on whether or not future investors will lend to the country. Alesina et al. (1990) argue that, if investors today expect their future counterparts not to lend and if this prospect implies a default on the debt offered today, then today's investors are not willing to hold the country's debt. This triggers a default and, following it, future investors will not lend to the country, making the initial expectations self-fulfilling. The present paper shows this type of coordination failure is eliminated if the setting is modified to one where the country is forced to pay its debt over a long but finite horizon or default. As a result, investors at that future date would be willing to lend to a fundamentally sound country under the expectation that their future counterparts will not. That is enough to ensure through a simple backward-induction argument that the country is able to borrow today. The country can self-impose the constraint that it must pay its debt before that future date or be forced to default by issuing state-contingent securities that pay a large amount (enough to force a default) if that condition is not met, and pay zero otherwise. The findings of this paper cast doubt on debt crises explanations that emphasize a self-fulfilling run on the public debt, since such run could be prevented by the mechanisms described.3 However, it is not clear whether these coordination mechanisms would be of help in a context where the lending is made to several decentralized borrowers. Externalities among those borrowers may allow for economy-wide debt runs that are more robust to the introduction of the coordination mechanisms. For example, in the “third generation” currency crisis models of Aghion et al., 2001 and Aghion et al., 2004 and Krugman (1999), credit constraints interact with balance sheet mismatches in such a way that foreign investors are only willing to lend to a given borrower if the other investors lend to the other borrowers in that economy. Since no individual borrower internalizes the effects of his or her actions on aggregate lending, the coordination mechanisms described in this paper may not be applicable. By challenging explanations based on self-fulfilling runs at the level of an individual borrower, such as the government, this paper suggests that “investor panic” arguments are more likely to be relevant when articulated in the context of broader types of economy-wide coordination failures. This has a number of interesting implications. For example, having many small illiquid borrowers makes an economy more vulnerable to investor panics than having a single aggregate illiquid borrower would. The remainder of the paper is organized as follows: Section 2 lays out a basic environment to illustrate the standard arguments for self-fulfilling liquidity crises. Section 3 presents the mechanisms that can eliminate such crises. Finally, Section 4 discusses the implications of this paper's findings and concludes.

Runs on the debt of an aggregate borrower can be prevented by the mechanisms described above. But matters can become more complicated if the debt is contracted by several decentralized private borrowers who do not internalize the effect of their decisions on the aggregate economy. There are a number of channels that can cause an investor not to lend to a borrower if other investors do not lend to the other borrowers in that economy. For example, the aggregate credit crunch can cause a real depreciation, which can lead to default if the borrowers have currency mismatches in their balance sheets (Krugman, 1999, Aghion et al., 2001 and Aghion et al., 2004). A previous version of this paper modeled a decentralized economy where contract enforcement weakened in the event of widespread default. That contract enforcement externality could lead to economy-wide debt runs as creditors “rush to the exit”. In a decentralized economy, the solution to the coordination failure among investors within the same period would require that they be allowed to condition their lending on the aggregate lending to the home economy as a whole. If they move simultaneously, such coordination will be difficult and require additional mechanisms. Problems are even more severe in the case of the inter-period coordination failure. Moreover, even if these barriers can be overcome, there is a free-rider problem. Even a small private cost can compromise a coordination effort since a small borrower's vulnerability to this type of crisis does not depend on whether or not she joins the mechanism, only on whether enough other borrowers do so. In principle, the government could consolidate all the private liabilities and then use the mechanisms from Section 3 to coordinate the economy in the good equilibrium. In theory, the government could issue new debt in order to take over those liabilities and eventually collect the repayments from the private borrowers it rescued. But even if such action does not affect the government's ability to repay the additional debt, it could affect its willingness to do so, since the government can keep the repayments from the borrowers it rescued while defaulting on the public debt. Thus, even if net public liabilities remain constant, the government may not be able to borrow against future claims if doing so would bring its gross liabilities beyond the threshold for which it strategically defaults. This limits the government's ability to remove investor coordination failures in a decentralized economy, as shown in Chamon (2003). This paper has challenged investor panic arguments articulated in the context of a run on the government's debt (or on an individual borrower's debt). This suggests that short-term public debt per se is not as risky as much of the existing literature implies since its “roll-over risk” can in principle be eliminated. But self-fulfilling features can still play a major role in the context of economy-wide coordination failures, which cannot be prevented by the mechanisms proposed in this paper. This suggests that having many small and decentralized illiquid borrowers makes an economy more vulnerable to investor panics than having a large aggregate illiquid borrower would.