Working Paper

Avoiding Sovereign Default Contagion: A Normative Analysis

Abstract: Should debtor countries support each other during sovereign debt crises? We answer this question through the lens of a two-country sovereign-default model that we calibrate to the euro-area periphery. First, we look at cross-country bailouts. We find that whenever agents anticipate their existence, bailouts induce moral hazard an reduce welfare. Second, we look at the borrowing choices of a global central borrower. We find that it borrows less than individual governments and, as such, defaults become less frequent and welfare increases. Finally, we show that central borrower's policies can be replicated in a decentralized setting with Pigouvian taxes on debt.

Keywords: Sovereign default; Sovereign contagion; Bailouts; Pigouvian taxes;

JEL Classification: F34; F41; F45; H63;

https://doi.org/10.17016/IFDP.2020.1275

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2020-02-27

Number: 1275