The Economics of Sovereign Debt, Bailouts and the Eurozone Crisis

Abstract

Despite a formal 'no-bailout clause', we estimate significant net present value transfers from the European Union to Cyprus, Greece, Ireland, Portugal and Spain, ranging from roughly 0.5% (Ireland) to 43%(Greece) of 2011 output during the recent Eurozone crisis.We propose a model to analyze and understand bailouts in a monetary union, and the large observed differences across countries.We characterize bailout size and likelihood as a function of the economic fundamentals (economic activity, debt-to-gdp ratio, default costs).Our model embeds a 'Southern view' of the crisis (transfers did not help) and a 'Northern view' (transfers weaken fiscal discipline).While a stronger no-bailout commitment reduces risk-shifting, it may not be optimal from the perspective of the creditor country, even ex-ante, if it increases the risk of immediate insolvency for high debt countries.Hence, the model provides a potential justification for the often decried policy of 'kicking the can down the road'.

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