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Fiscal Discoveries and Sudden Decouplings

Author

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  • Catão, Luis A. V.
  • Fostel, Ana
  • Rancière, Romain

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.

Suggested Citation

  • Catão, Luis A. V. & Fostel, Ana & Rancière, Romain, 2013. "Fiscal Discoveries and Sudden Decouplings," CEPR Discussion Papers 9368, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:9368
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    References listed on IDEAS

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    More about this item

    Keywords

    Default; Eurozone Debt Crisis; Fiscal Gaps; Information Asymmetry; Perfect Bayesian Equilibrium; Pesistence; Sovereign Debt; Volatility;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents

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