Lifetime-Laffer Curves and the Eurozone Crisis

In a finite-horizon model of sovereign debt and default, I show that long-term debt and the lack of ability to commit to future debt issuance can give rise to a multiplicity of debt and spread trajectories despite the ability to commit to contemporaneous debt issuance in terminal periods. This multiplicity bears resemblance to recent events in the Peripheral Eurozone. In a simple calibrated exercise, I find that 380 basis points (84.6%) of the spread during the crisis may be imputable to such coordination failures; if the model is extended to include bank bailouts, it can also explain 46.63 percentage points (37.8%) of the debt-to-GDP build-up. Policy analysis reveals that both austerity measures and liquidity provision by the central bank can eliminate malignant debt trajectories, but that the latter is more likely to have resolved the crisis.