Sovereign risk: the return
Paris School of Economics
21 January 2016, 10:00-12:00
MW Common Room
Europe has recently been hit by a sovereign debt crisis which has caused three of its members to be ousted from financial markets. Those three countries, Greece, Ireland and Portugal, had to ask for the support of the other eurozone countries to refinance their debt. Additionally, in the case of Greece the eventual implementation of a nominal haircut of more than 50% was decided. In response to this unexpected crisis, Europe chose to impose a much stricter budgetary discipline, aiming for a near zero deficit rule. How did the eurozone suddenly become so vulnerable to sovereign risk? Is Europe overreacting by imposing budget constraints that are too restrictive?
Sovereign debt crisis specialists have been asked for answers. Trying to understand why some countries default is the theme of a large body of literature. Why do countries default? This seemingly simple question has yet to be adequately answered in the literature. Indeed, prevailing modelling strategies compel us to choose between two unappealing model features: depending on the cost of default selected by the modeler, either the debt ratios are too high and the probability of default is too low or the opposite is true. In view of the historical evidence that countries always default after a crisis, we propose a novel approach to the theory of debt default and develop a model that matches the key stylized facts regarding sovereign risk