Sovereign Risk Shocks and Fiscal Rules

We study how sovereign risk fluctuations propagate to the real economy when banks hold long-term public debt. Using Italian data, we decompose spread-implied default probabilities into a systematic debt-driven component and an exogenous component capturing shifts in perceived sovereign risk. We embed this decomposition in a quantitative New-Keynesian model with constrained financial intermediaries and endogenous default risk, solved to a third order and estimated by simulated method of moments. Higher perceived default risk lowers sovereign bond prices, weakens bank net worth, tightens intermediary constraints, and depresses investment and output. Because default risk also responds to debt dynamics, the downturn amplifies sovereign risk through a sovereign-bank loop. We find that sovereign risk shocks account for about one fifth of output fluctuations and roughly one third of welfare costs at the business cycle frequency. Fiscal policy can mitigate this loop, but only by moving distortionary taxes. Consumption-tax rules deliver the largest welfare gains, whereas deficit-based rules can generate excessive tax volatility and large welfare losses.