Heterogeneous Market Beliefs, Fundamentals and the Sovereign Debt Crisis in the Eurozone

Abstract

The unprecedented sovereign debt crisis across the eurozone has prompted a new generation of models with 'self-fulfilling' attacks on public debt. The model presented in this paper shows that multiple equilibria arise as investors have no direct information, and form heterogeneous rational beliefs, about the government's sustainable limit of the solvency primary balance. If beliefs of insolvency are sufficiently large, then the government is bound to default, although initial solvency conditions are satisfied. Several issues are discussed concerning the role of initial conditions, fiscal shocks and the policy options to escape from the default domain.

Interest Rate Targets and Speculative Attacks on Public Debt

“…In particular, Tamborini (2015) shows how the credibility of the fiscal consolidation required in order to stabilize public debt may be questioned by the feasibility of the primary surplus that a government can run. The expectation of an upper threshold that limits the social feasibility of the primary surplus-due to the existence of an upper limit on the revenues that a government can excise from its citizens and of a lower limit on the expenditures that it can cut-works exactly as the upper band of a target zones regime.…”

“…The term f t is the primary public deficit-to-GDP ratio (namely e t − t t , where e t is government's fiscal expenditure-to-GDP and t t are government revenues-to-GDP) and the term m t is the monetization rate of public debt (see Tamborini, 2015). The term (i t − g t )b t is the service on the debt as a ratio of GDP.…”

“…The fiscal authority operates in order to stabilize the steady-state value of public debt-to-GDP,b. For that to happen, by imposing db t = 0 in (5), assuming that no help can come from the monetary side, namely that m t = 0 (Tamborini, 2015), it turns out that the long run primary surplus/deficit (calculated in the steady state, in which there are no stochastic shocks) has to cover the long-term service on the debt:…”

“…The nonlinearity can be explained instead by concluding that the crisis was driven by negative self-fulfilling expectations, rather than by diverging economic fundamentals (De Grauwe and Ji, 2013a). By adopting a model of heterogeneous markets' expectations about the uncertain level of the country's maximum feasible primary budget surplus, Tamborini (2015) provides an alternative explanation for both puzzles. He shows that the risk premium on public debt rises dramatically when the primary surplus that is necessary to grant debt stabilization approaches its maximum feasibility limit.…”

Determinants of sovereign defaults

“…Compared to late 1980s and early 1990s when financial markets cooled down and sovereign defaults were few leading to less academic research on foreign borrowing crisis, the number of studies since 2014 on sovereign debt crisis have been regularly forthcoming in particular of European countries. Some of these studies include Ucler & Kirmizioglu (2015), Tamborini (2015), Broto & Perez-Quiros (2015), Popov & Van Horen (2015), Smeets (2016), Moisescu & Giurescu (2016), Stamatopoulos et al (2016), Gómez-Puig & Sosvilla-Rivero (2016), Afonso & Silva (2017), Cencini (2017), Reusens & Croux (2017), and Ehrmann & Fratzscher (2017). A significant number of these studies have used time series models to evaluate credit default swaps (CDS) and other similar instruments to assess the riskiness of a country due to the ever rising burden of sovereign debt.…”