Fiscal Discoveries and Sudden Decouplings

61 Pages Posted: 26 Feb 2013

See all articles by Luis A. V. Catão

Luis A. V. Catão

Inter American Development Bank

Ana Fostel

University of Virginia

Romain G. Rancière

University of Southern California

Date Written: February 2013

Abstract

The recent Eurozone debt crisis has witnessed sharp decouplings in cross-country bond yields without commensurate shifts in relative fundamentals. We rationalize this phenomenon in a model wherein countries with different fundamentals are on different equilibrium paths all along, but which become discernable only during bad times. Key ingredients are cross-country differences in the volatility and persistence of fiscal revenue shocks combined with asymmetric information on country-specific fiscal shocks. Differences in the cyclicality of fiscal revenues affect the option value of borrowing and resulting default risk; unobservability of fiscal shocks makes bond pricing responsive to market actions. When tax revenues are hit by common positive shocks, no country increases net debt and interest spreads stay put. When a common negative revenue shock hits and is persistent, low volatility countries adjust spending while others resort to borrowing. This difference signals a relative deterioration of fiscal outlooks, interest spreads jump and decoupling takes place.

Keywords: Default, Eurozone Debt Crisis, Fiscal Gaps, Information Asymmetry, Perfect Bayesian Equilibrium, Pesistence, Sovereign Debt, Volatility

JEL Classification: E62, F34, G15, H3

Suggested Citation

Catão, Luis A. V. and Fostel, Ana and Rancière, Romain G., Fiscal Discoveries and Sudden Decouplings (February 2013). CEPR Discussion Paper No. DP9368. Available at SSRN: https://ssrn.com/abstract=2224293

Luis A. V. Catão (Contact Author)

Inter American Development Bank ( email )

Ana Fostel

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

Romain G. Rancière

University of Southern California ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

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