Chronic sovereign debt crises in the Eurozone, 2010-2012

Cristina Arellano, Juan Carlos Conesa and Timothy Kehoe

No 12-4, Economic Policy Paper from Federal Reserve Bank of Minneapolis

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.

Date: 2012
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