The Economics of Sovereign Debt, Bailouts, and the Eurozone Crisis

IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2023 AUG The Economics of Sovereign Debt, Bailouts, and the Eurozone Crisis Pierre-Olivier Gourinchas, Philippe Martin, and Todd Messer WP/23/177 © 2023 International Monetary Fund WP/23/177IMF Working Paper* Research Department The Economics of Sovereign Debt, Bailouts, and the Eurozone Crisis Prepared by Pierre-Olivier Gourinchas, Philippe Martin, and Todd Messer Authorized for distribution by Pierre-Olivier Gourinchas August 2023 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: Despite a formal ‘no-bailout clause,’ we estimate significant net present value transfers from the European Union to Cyprus, Greece, Ireland, Portugal, and Spain, ranging from roughly 0.5% (Ireland) to a whopping 43% (Greece) of 2010 output during the Eurozone crisis. We propose a model to analyze and understand bailouts in a monetary union, and the large observed differences across countries. We characterize bailout size and likelihood as a function of the economic fundamentals (economic activity, debt-to-gdp ratio, default costs). Our model embeds a ‘Southern view’ of the crisis (transfers did not help) and a ‘Northern view’ (transfers weaken fiscal discipline). While a stronger no-bailout commitment reduces risk-shifting, it may not be optimal from the perspective of the creditor country, even ex-ante, if it increases the risk of immediate insolvency for high debt countries. Hence, the model provides a potential justification for the often decried policy of ‘kicking the can down the road.’ Mapping the model to the estimated transfers, we find that the main purpose of the outsized Greek bailout was to prevent an exit from the eurozone and possible contagion. Bailouts to avoid sovereign default were comparatively modest. JEL Classification Numbers: G15, F34, F45 Keywords: Euro area; Monetary Union; Sovereign debt; bailouts Author’s E-Mail Address: pgourinchas@imf.org, philippe.martin@sciencespo.fr, todd.e.messer@frb.gov *The working paper published by FED, NBER and CBER and can be found at:FEDNBERCEPR WORKING PAPERS The Economics of Sovereign Debt, Bailouts, and the Eurozone Crisis Prepared by Prepared by Pierre-Olivier Gourinchas, Philippe Martin, and Todd Messer 1 1We thank Philippe Aghion, Javier Bianchi (discussant), Daniel Cohen (discussant), Gita Gopinath, Alberto Martin (discussant), Dirk Niepelt and Jeromin Zettelmeyer for insightful discussions as well as seminar participants at CEPR-ESSIM, NBER-IFM, the Federal Reserve Bank of Dallas-University of Houston-Banco de Mexico 3rd International Conference on International Economics, Banque de France, Stockholm University, University of Oslo, IESE Business School, Boston College, University of Michigan, UC Riverside, Columbia. The first draft of this paper was written while P-O. Gourinchas was visiting Harvard University, whose hospitality is gratefully acknowledged. We thank the Fondation Banque de France and the Banque de France-Sciences Po partnership for its financial support. We are particularly grateful to Aitor Erce for his comments and help on the data on official loans. The views in this paper are the responsibility of the authors and do not necessarily represent those of the Federal Reserve Board, the Federal Reserve System, the IMF, its Executive Board, or IMF Management. 1 Introduction.‘The markets are deluding themselves when they think at a certain point the other memberstates will put their hands on their wallets to save Greece.’ECB Executive Board member, J ́urgen Stark (Reuters, 2010, January 10)‘The euro-region treaties don’t foresee any help for insolvent countries, but in reality the otherstates would have to rescue those running into difficulty.’German finance minister Peer Steinbrueck (The Financial Times, 2009, February 18)‘No, Greece will not default. Please. In the euro area, the default does not exist.’Economics Commissioner Joaquin Almunia (Reuters, 2009, January 29)As the Eurozone crisis of 2010-2015 highlighted, a potential default on government debt within a mon-etary union comprised of sovereign members involves unique features that affect the potential costsand benefits to debtor and creditor countries. A monetary union facilitates financial integration. Withlarge within-union cross-border holdings of financial assets, including government debt held by banks,the exposure of creditor countries inside the union to sovereign risk is high. In addition, monetary andeconomic unions usually go hand in hand, fos