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International Bailouts: Why Did Banks' Collective Bet Lead Europe to Rescue Greece?

Listed author(s):
  • E. Mengus

In this paper, I use a two-country model to investigate the incentives which lead one country to take charge of another country's debt. I show that, when direct transfers to residents cannot be perfectly targeted, the first country can be better o_ honoring the second country's liabilities, even if this means paying o_ foreign creditors. Anticipating the ex post rescue, private agents engage in a collective bet on the foreign country's debt, leading to the emergence of a self-fulfilling implicit guarantees in equilibrium. In response to the resulting inefficient outcome, the optimal policy for the rescuing country's government is to restrict domestic exposures to foreign debt ex ante, for example, through a tax on capital outflows. Finally, I argue that these findings can shed light on the European sovereign debt crisis, the interventions of the IMF, the 1790 US federal bailout of states and on the 2008 US financial crisis.

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File URL: https://publications.banque-france.fr/sites/default/files/medias/documents/working-paper_502_2014.pdf
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Paper provided by Banque de France in its series Working papers with number 502.

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Length: 60 pages
Date of creation: 2014
Handle: RePEc:bfr:banfra:502
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Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS

Web page: http://www.banque-france.fr/

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