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Chronic sovereign debt crises in the Eurozone, 2010-2012

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  • Cristina Arellano
  • Juan Carlos Conesa
  • Timothy J. Kehoe

Abstract

Two years after the rescue package for Greece provided by the European Union and the International Monetary Fund in May 2010, sovereign debt crises continue to threaten a growing number of countries in the eurozone. We develop a theory for analyzing these crises based on the research of Cole and Kehoe (1996, 2000) and Conesa and Kehoe (2012). In this theory, the need to frequently sell large quantities of bonds leaves a country vulnerable to sovereign debt crisis. This vulnerability provides a strong incentive to the country’s government to run surpluses to pay down its debt to a level where a crisis is not possible. ; A deep and prolonged recession, like those currently afflicting many eurozone countries, creates a conflicting incentive, however, to “gamble for redemption”—to bet that the recession will soon end, to sell more bonds in order to smooth government spending, and, if indeed the economy recovers, to reduce debt. Under some circumstances, this policy is the best that a government can do for the citizens of its country, but it carries a risk: If the recession continues too long, the government either will have to stop increasing its debt or will have to default on its bonds. ; The theory suggests that policies that result in high interest rates on government bonds and high costs of default provide incentives for a government to reduce its debt and avoid sovereign default. On the other hand, policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. We conclude that policy interventions taken to date by the EU and the IMF—by lowering the cost of borrowing and reducing default penalties—have encouraged eurozone governments to gamble for redemption.

Suggested Citation

  • Cristina Arellano & Juan Carlos Conesa & Timothy J. Kehoe, 2012. "Chronic sovereign debt crises in the Eurozone, 2010-2012," Economic Policy Paper 12-4, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmep:12-4
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    References listed on IDEAS

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    1. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    2. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    3. Juan Carlos Conesa & Timothy J. Kehoe, 2017. "Gambling for redemption and self-fulfilling debt crises," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(4), pages 707-740, December.
    4. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 91-116.
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    Cited by:

    1. Adler, Gustavo & Lizarazo, Sandra, 2015. "Intertwined sovereign and bank solvencies in a simple model of self-fulfilling crisis," International Review of Economics & Finance, Elsevier, vol. 39(C), pages 428-448.
    2. repec:spr:joecth:v:64:y:2017:i:4:d:10.1007_s00199-015-0939-y is not listed on IDEAS
    3. Kim Ruhl & Joseph Steinberg & Timothy Kehoe, 2013. "Global Imbalances and Structural Change in the United States," 2013 Meeting Papers 1089, Society for Economic Dynamics.
    4. Gonzalo Fernandez-de-Cordoba & Pau Pujolas & Jose Torres, 2017. "Fiscal Discipline and Defaults," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 24, pages 1-13, March.
    5. Mirdala, Rajmund & Ruščáková, Anna, 2015. "On Origins and Implications of the Sovereign Debt Crisis in the Euro Area," MPRA Paper 68859, University Library of Munich, Germany.
    6. repec:spr:joecth:v:64:y:2017:i:4:d:10.1007_s00199-017-1085-5 is not listed on IDEAS
    7. Timothy J. Kehoe & Kim J. Ruhl & Joe Steinberg, 2013. "What will happen when foreigners stop lending to the United States?," Economic Policy Paper 13-4, Federal Reserve Bank of Minneapolis.
    8. Gonzalo F. de-Córdoba & José L. Torres, 2016. "Public debt frontiers: The Greek case," Working Papers 2016-03, Universidad de Málaga, Department of Economic Theory, Málaga Economic Theory Research Center.
    9. Juan Carlos Conesa & Timothy J. Kehoe, 2017. "Gambling for redemption and self-fulfilling debt crises," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(4), pages 707-740, December.
    10. Gustavo Adler, 2012. "Intertwined Sovereign and Bank Solvencies in a Model of Self-Fulfilling Crisis," IMF Working Papers 12/178, International Monetary Fund.

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