Market Opinions, Fundamentals and the Euro-Sovereign Debt Crisis
University of Trento Department of Economics Research Paper No. 9
42 Pages Posted: 8 Nov 2012
Date Written: November 7, 2012
The unprecedented sovereign debt crisis across the European Monetary Union has prompted a new generation of models with "self-fulfilling" attacks to public debt. The key idea is that governments may be forced to default even though initial fundamental fiscal variables are sound. The model presented in this paper has two main features: (i) the government's default decision arises out of a cost-benefit analysis that sets the sustainable limit of the solvency primary balance; (ii) investors have no direct information about this variable, and are charaterized by a frequency distribution of "educated opinions". As a consequence, a "good" and "bad" state of the debt market are possibile; the latter is unstable and the model identifies an attraction domain of default within which the government is bound to default although initial solvency conditions are sustainable. A novel feature of the model is that the extent of this domain may be larger or smaller depending on the interplay between fiscal fundamentals and the distribution of investors' opinions. I then discuss several issues concerning the role of initial conditions, fiscal shocks, and the policy options to escape from the default domain. Under this new light, the institutional design of the European Monetary Union now appears seriously deficient and largely co-responsible for the gravity of the crisis.
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