The Institute for Economic Development at Boston University                                                                Research Review Spring 2000

“Confidence Crises Revisited: Is Short-Term Debt a Curse or a Blessing?”

Marialuz Moreno-Badia

Recent episodes of financial turmoil like the Mexican crisis in 1994-95 or the Brazilian crisis in January 1999 have given impetus to a flourishing literature on confidence crises. In the context of sovereign debt, confidence crises occur when foreign investors fear that the government will be unable to honor its commitments on bonds, leading to a self-fulfilling default. A number of papers have analyzed whether the danger of a confidence crisis can be reduced by acting on the maturity structure of public debt. For example, according to Alesina, et. al. (1990); Giavazzi and Pagano (1990) and Cole and Kehoe (1996), a crisis of confidence in the public debt can be self-fulfilling but it is less likely to occur if the public debt has a long and balanced maturity structure.

However, if short-term debt is the main cause of confidence crises, why is it that governments insist on issuing short-term debt? A possible answer is that it is cheaper to borrow short. Interestingly however, under a confidence crisis, short-term debt can be very expensive from a social point of view. This paper analyzes the optimal maturity structure of public debt when the government tries to simultaneously minimize the expected cost of debt servicing and the vulnerability to confidence crisis. It examines a three period model where taxes are distorting, and the government has an incentive to smooth taxes over time by using the maturity structure of debt. An important feature of the model is the existence of exogenous uncertainty in the form of political elections in a two-party system.

The model permits an evaluation of the optimal maturity structure of debt given that confidence crises are possible. In particular, if the likelihood of a confidence crisis is high enough, the optimal maturity structure of debt will shorten beyond perfect tax smoothing and avoid debt crises. Otherwise, the optimal maturity structure may shorten but confidence crises could still happen. In contrast with most of the literature on confidence crises, the model suggests that short-term debt can be a blessing rather than a curse. In that case, a policy that lengthens the maturity structure of debt could be a problem.