Working Paper: NBER ID: w16899
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: Sovereign debt; Banking crises; Contagion; Financial integration; Fiscal policy
JEL Codes: E44; E62; F15; F34; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial integration (F30) | inefficient equilibrium in the supply of government debt (D52) |
| banking sector's demand for government bonds (G21) | government debt management policies (H63) |
| contagion risk from sovereign default (F65) | investment and output growth (E22) |
| loss of government debt credibility (H63) | diminished economic activity (R11) |
| diminished economic activity (R11) | exacerbated government’s ability to manage its debt (H63) |
| financial integration (F30) | contagion risk from sovereign default (F65) |
| structure of financial systems (G20) | outcomes of sovereign debt crises (F34) |