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Escape Routes from Sovereign Default Risk in the Euro Area

Willi Semmler ^a,b

Christian R. Proaño ^c

^aDepartment of Economics, The New School of Social Research, New York, NY, USA

^bZentrum für Europäische Wirtschaftsforschung (ZEW), Mannheim, Germany, e-mail: semmlerw@newschool.edu

^cEconomics Department, University of Bamberg, Germany; Macroeconomic Policy Institute (IMK), Düsseldorf, Germany

Monetary Policy in the Context of the Financial Crisis: New Challenges and Lessons

ISBN: 978-1-78441-780-2, eISBN: 978-1-78441-779-6

Publication date: 1 July 2015

Abstract

The recent financial and sovereign debt crises around the world have sparked a growing literature on models and empirical estimates of defaultable debt. Frequently households and firms come under default threat, local governments can default, and recently sovereign default threats were eminent for Greece and Spain in 2012–2013. Moreover, Argentina experienced an actual default in 2001. What causes sovereign default risk, and what are the escape routes from default risk? Previous studies such as Arellano (2008), Roch and Uhlig (2013), and Arellano et al. (2014) have provided theoretical models to explore the main dynamics of sovereign defaults. These models can be characterized as threshold models in which there is a convergence toward a good no-default equilibrium below the threshold and a default equilibrium above the threshold. However, in these models aggregate output is exogenous, so that important macroeconomic feedback effects are not taken into account. In this chapter, we (1) propose alternative model variants suitable for certain types of countries in the EU where aggregate output is endogenously determined and where financial stress plays a key role, (2) show how these model variants can be solved through the Nonlinear Model Predictive Control numerical technique, and (3) present some empirical evidence on the nonlinear dynamics of output, sovereign debt, and financial stress in some euro areas and other industrialized countries.

Keywords

Acknowledgements

Acknowledgments

The research for this chapter was partly conducted while Willi Semmler was a visiting researcher at the European Central Bank (ECB), and Christian R. Proaño was a visiting researcher at the Deutsche Bundesbank. They would like to thank the ECB and the Deutsche Bundesbank for their hospitality and financial support, as well as Christian Schoder for helpful comments and suggestions. This chapter represents the authors’ personal opinions and does not necessarily reflect the views of the ECB or the Deutsche Bundesbank.

Citation

Semmler, W. and Proaño, C.R. (2015), "Escape Routes from Sovereign Default Risk in the Euro Area", Monetary Policy in the Context of the Financial Crisis: New Challenges and Lessons (International Symposia in Economic Theory and Econometrics, Vol. 24), Emerald Group Publishing Limited, Leeds, pp. 163-193. https://doi.org/10.1108/S1571-038620150000024018

Publisher

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Emerald Group Publishing Limited