Sovereign debt and multiple equilibria

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Sovereign debt and multiple equilibria

• Steinar Holden
• Department of Economics, UiO
• http//folk.uio.no/sholden/
• ECON 4325
• 3 May 2013

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Lower interest rates for EMU countries in 2099
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But not in 2011 what had happened?
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Countries without national central bank are more
vulnerable for debt crises
Estimate 2011 percent of GDP Estimate 2011 percent of GDP Estimate 2011 percent of GDP
Budget balance Primary balance Gross debt Net debt
Great Britain -8.8 -5.6 81 73
Spain -6.1 -4.4 67 56
Kilde IMF Fiscal Monitor September 2011 Kilde IMF Fiscal Monitor September 2011 Kilde IMF Fiscal Monitor September 2011

• In spite of this, Great Britain has been
  borrowing at 2.5 interest rate, and Spain at
  over 5

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Debt in foreign currency without national
central bank
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Total financing needs 2012 maturing debt green,
budget deficit blue
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Two equilibria

• Good equilibrium
• The market expects the debt to be paid
• The interest rate is low, and the debt can be
  paid
• Bad equilibrium
• The market fears that the debt will not be paid
• The interest rate becomes so high that debt is
  not paid
• Self fullfilling expectations can give rise to a
  liquidity crisis gt vast costs
• The central bank can buy government bonds
• Bad equilibrium can be avoided

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Central banks buy govt debt
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Fiscal policy and the financial crisis
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The Walters effect monetary policy in a
monetary union

• The same nominal interest rate prevails
  throughout the EMU
• A country with a booming economy will have higher
  wage and price growth
• Lower real interest rate will stimulate the boom
• A country in a downturn will have lower wage and
  price growth
• Higher real interest rate will amplify the
  downturn
• Unavoidable destabilizing mechanism

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Trade balance in the euro area
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Increasing public debt in advanced economies