Working Paper: CEPR ID: DP8358
Authors: Patrick Bolton; Olivier Jeanne
Abstract: We analyze contagious sovereign debt crises in financially integrated economies. Under financial integration banks optimally diversify their holdings of sovereign debt in an effort to minimize the costs with respect to an individual country's sovereign debt default. While diversification generates risk diversification benefits ex ante, it also generates contagion ex post. We show that financial integration without fiscal integration results in an inefficient equilibrium supply of government debt. The safest governments inefficiently restrict the amount of high quality debt that could be used as collateral in the financial system and the riskiest governments issue too much debt, as they do not take account of the costs of contagion. Those inefficiencies can be removed by various forms of fiscal integration, but fiscal integration typically reduce the welfare of the country that provides the "safe-haven" asset below the autarky level.
Keywords: banking; collateral; european debt crisis; european monetary union; financial contagion; government debt; government default; international financial integration
JEL Codes: E44; F34; F36; G21; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial integration (F30) | banks diversify sovereign debt holdings (F34) |
| banks diversify sovereign debt holdings (F34) | risk diversification benefits (G11) |
| banks diversify sovereign debt holdings (F34) | contagion risks (F65) |
| lack of fiscal integration (H77) | inefficiencies in government debt supply (H63) |
| inefficiencies in government debt supply (H63) | safe governments restrict high-quality debt issuance (H74) |
| inefficiencies in government debt supply (H63) | risky governments issue excessive amounts of debt (H63) |
| financial integration (F30) | uneven distribution of benefits (D30) |
| uneven distribution of benefits (D30) | welfare losses for safe haven countries (D69) |
| sovereign default and banking crises (F65) | decline in private credit (G21) |
| sovereign default (F34) | adverse impact on banking sector (F65) |
| adverse impact on banking sector (F65) | reduction in overall economic activity (F69) |