Working Paper: CEPR ID: DP10459
Authors: Sylvester C.W. Eijffinger; Michal L. Kobielarz; Burak R. Uras
Abstract: The European sovereign debt crisis is characterized by the simultaneous surge in borrowing costs in the GIPS countries after 2008. We present a theory, which can account for the behavior of sovereign bond spreads in Southern Europe between 1998 and 2012. Our key theoretical argument is related to the bail-out guarantee provided by a monetary union, which endogenously varies with the number of member countries in sovereign debt trouble. We incorporate this theoretical foundation in an otherwise standard small open economy DSGE model and explain (i) the convergence of interest rates on sovereign bonds following the European monetary integration in late 1990s, and (ii) - following the heightened default risk of Greece - the sudden surge in interest rates in countries with relatively sound economic and financial fundamentals. We calibrate the model to match the behavior of the Portuguese economy over the period of 1998 to 2012.
Keywords: bailout; contagion; interest rate spreads; sovereign debt crisis
JEL Codes: F33; F34; F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bailout guarantees (H81) | sovereign bond spreads (H63) |
| default risk of one member country (e.g., Greece) (F34) | increased borrowing costs for Portugal (F34) |
| bailout expectations (G28) | borrowing costs (H74) |
| initial default of Greece (F01) | contagion effects (E44) |
| contagion effects (E44) | rising interest rates in other countries (E49) |
| regime switch from cooperative to standalone (P13) | contagion mechanism (E44) |