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Sovereign debt bailouts backfire: Fed analysis

Sovereign debt bailouts are counterproductive, concludes an analysis published by the United States Federal Reserve (Fed).

In general, sovereign debt crises occur in waves, spreading from one country to another.

The euro area debt crisis of 2011-12 is a good example of this. The tension in the sovereign debt market quickly spread from Greece and Ireland to Portugal, Spain and Italy.

After this crisis, an interesting debate has arisen about the advisability of agreements between countries aimed at reducing contagion in the sovereign market.

On the one hand, some have argued that such agreements are necessary to reduce contagion effects between countries.

On the other hand, some have expressed concern that agreements between countries could lead to moral hazard, with countries issuing excessive debt and defaulting more frequently.

Sovereign debt

More recently, the debate has gained renewed attention in the euro area in light of the fiscal stress imposed on some countries by the Covid-19 crisis.

Through the lens of a two-country sovereign debt default model, the analysis quantitatively assesses how a set of cross-country policies affects government borrowing decisions, default risk, and household welfare.

In the document, prepared by Sergio de Ferra1 and Enrico Mallucci, both discover that ex post policies, such as bailouts, are counterproductive, since they induce moral hazard and lead to a decrease in well-being.

On the contrary, ex ante policies, such as closer coordination of government borrowing policies, are effective as they mitigate contagion and improve welfare.

 Pigouvian Taxation

 

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