Sovereign Risk under Diagnostic Expectations

This paper studies the effects of overreaction to recent news for macroeconomic outcomes in the context of a quantitative model of sovereign debt and default. Overreaction is formalized in terms of diagnostic expectations that excessively extrapolate from current conditions. Examining historical IMF growth forecasts, we find empirical evidence for this behavior and incorporate it into an otherwise standard model of long-term sovereign debt. The model successfully matches salient business cycle statistics, including the distribution of sovereign spreads, and also predicts an empirically plausible default frequency. Counterfactual experiments indicate that diagnostic expectations induce sizeable welfare losses, the bulk of which could be eliminated under rational behavior of the sovereign borrower. This motivates our analysis of fiscal rules in the form of debt or spread limits, which need to trade-off their beneficial effects via reduced debt dilution against the fact that they condition on aggregates that may be subject to market sentiment.