From debt crisis to sovereign risk

Abstract

Recent experience taught us that advanced economies can be subject to debt crises, with tremendous impact on the economy. Such crises are -fortunately- rare events with which policy makers do not have to deal on a daily basis. They do have to incorporate sovereign risk, the probability that such a crisis occurs, in their decisions tough. The main motivation and focus of this thesis is the challenge the presence of sovereign risk brings for policy makers. Chapter 2 and Chapter 3 deal with assessing the probability of a debt crisis. Chapter 2 uses long term time series of public finances for 9 OECD countries and shows that a simulation that takes economic uncertainty and the expected response of the government to that into account can inform on future debt sustainability. Chapter 3 uses financial market data on default risk for sovereigns and banks in Europe and investigates the directional spill-overs between them. It finds that prior to the crisis bank and government bonds were substitutes, whereas they are complements now. Three channels contribute to this effect: direct holdership of government bonds by banks, implicit bail-out guarantees and effects via the state of the economy. Chapter 4 and Chapter 5 then take sovereign risk as given and ask what the presence of sovereign risk implies. In Chapter 4 the goal is to see whether a stable and unique macroeconomic solution exists under sovereign risk as a function of monetary and fiscal policy stance. In a stable and unique solution the debt level is non-explosive and the price level is determinate. The central bank and the government need to coordinate their policies in the presence of sovereign risk. A deficit target for the government makes this easier to achieve. Chapter 5 focusses on the interaction of sovereign risk and the exchange rate regime. It shows that under a flexible exchange rate regime the exchange rate depreciates as the fiscal position deteriorates. The exchange rate depreciation supports exports, which is a stabilizing effect that counteracts the initial deterioration. When exchange rates are fixed, as they are for monetary union members, this mechanism is absent. Chapter 6 asks what the optimal fiscal policy is in the presence of sovereign risk. It finds that the optimal policy should respond much stronger to deviations in unemployment and debt from the steady state than it currently does. When this policy is applied variation in these variables is reduced at the cost of much more variation in fiscal policy.