When Do Currency Unions Benefit from Default?

Abstract

Since the Eurozone Crisis of 2010-12, a key debate on the viability of a currency union has focused on the role of a fiscal union in adjusting for country heterogeneity. However, a fully-fledged fiscal union may not be politically feasible. This paper develops a two-country international finance model to examine the benefits of the bankruptcy code of a capital markets union - in the absence of a fiscal union - as an alternative financial mechanism to improve the welfare of a currency union. When domestic credit risks are present, I show that a lenient union-wide bankruptcy code that allows for default in the cross-border capital markets union leads to a Pareto improvement within the currency union. However, if the union-wide bankruptcy code is too lenient, default may cause the collapse of the capital markets union and impede cross-border risk sharing. Moreover, the absence of floating exchange rates removes a mechanism to neutralise domestic credit risks; I show that softening the union-wide bankruptcy code can recoup the lost benefits of floating nominal exchange rates. The model provides the economic and welfare implications of bankruptcy within a capital markets union in the Eurozone.

Keywords: default, bankruptcy code, fiscal union, capital markets union, bank credit, inside money, price-level and exchange rate determinacy, liquidity intermediary asset pricing

JEL Classification: E64, F55, G37, G43