February 2020

Avoiding Sovereign Default Contagion: A Normative Analysis

Sergio de Ferra and Enrico Mallucci


Should debtor countries support each other during sovereign debt crises? We answer this question through the lens of a two-country sovereign-default model that we calibrate to the euro-area periphery. First, we look at cross-country bailouts. We find that whenever agents anticipate their existence, bailouts induce moral hazard an reduce welfare. Second, we look at the borrowing choices of a global central borrower. We find that it borrows less than individual governments and, as such, defaults become less frequent and welfare increases. Finally, we show that central borrower's policies can be replicated in a decentralized setting with Pigouvian taxes on debt.

Keywords: Sovereign default, sovereign contagion, bailouts, Pigouvian taxes

DOI: https://doi.org/10.17016/IFDP.2020.1275

PDF: Full Paper

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Last Update: February 27, 2020