We use more than one century of Argentine and Mexican data to estimate the structural parameters of a small-open-economy real-business-cycle model driven by nonstationary productivity shocks. We find that the RBC model does a poor job at explaining business cycles in emerging countries. We then estimate an augmented model that incorporates shocks to the country premium and financial frictions. We find that the estimated financial-friction model provides a remarkably good account of business cycles in emerging markets and, importantly, assigns a negligible role to nonstationary productivity shocks.

This paper examines the welfare effects of bailouts, policies that combine third-party sub- sidized loans with limits on sovereign borrowing, in economies exposed to sovereign debt risk and to financial stress. Our quantitative exercise focused on the Eurozone debt crisis shows that, ex-ante (i.e. before observing the exogenous path of the economy), bailouts are welfare improving and amount to 0.37 percent in consumption equivalent terms. However, ex-post(i.e. after observing the exogenous path of the economy), their desirability is much less cer- tain. If the crisis is short-lasting, bailouts have an overall positive effect. In this case the loan is repaid and the bailout acts as an additional consumption-smoothing asset that makes the economy better off. Crucially, however, we show that if the crisis is long-lasting and severe, economic bailouts can be undesirable. In this case the imposed borrowing limit may push the country into default, thereby increasing sovereign spreads and making the economy worse off than an economy without a bailout option.

In this paper we argue that an important and not-yet analyzed determinant of the observed heterogeneity of government debt across countries is the interaction between political conflicts and transparency of institutions. In the empirical part of the paper we show that whereas these two variables, per-se, are not a significant determinant of observed debt levels across countries, their interaction is a key factor to explain debt-levels heterogeneity. Specifically, political conflicts imply higher borrowing only in non-transparent economies. In the theoretical model we propose a rationale for this ef- fect. When the incumbent has preferences over distribution of resources across di↵erent groups, in a transparent economy political uncertainty leads to precautionary savings. Nevertheless, assuming that in more non-transparent economies the probability of an incumbent to be re-elected is more strongly a function of current economic conditions, then political uncertainty leads to borrowing incentives. We structurally estimate the two frictions in our model (political conflict and lack of transparency) by using their macroeconomic implications. Then, we compare the estimated frictions with the prox- ies for political conflict and lack of transparency in the data and we find a significant relationship, which supports our theory.

We propose a rationale for the existence of lending mechanisms, such as the IMF and the ESM, which provide lending to distress sovereigns. First, we show that perfectly competitive markets for sovereign bonds are characterized by the interest overhang externality: when the ownership of debt is anonymous and dispersed, the market price of newly issued bond might be too low to avoid default, even though preventing default would be in the interest of existing creditors. Then, we show that a policy maker/institution can address this externality by facilitating lending to the small open economy government at more favourable terms. This policy is ex-post Pareto improving: the borrower can enjoy credit at lower interest rates, while investors gain from the delay in default even though they are directly financing the policy. Finally, the ex-ante gains are tightly related to the fiscal policy used to finance the intervention. We prove the existence of a Pareto set of fiscal policies that makes the intervention beneficial for all agents.

  • Sovereign Default and Information Frictions [Work in Progress]
    with  Christian Hellwig  (Toulouse School of Economics) and Constance de Soyres (Toulouse School of Economics).

We develop a model of sovereign bond pricing based on dispersed information that can account quantitatively for the sovereign bond spread puzzle. The first contribution is to characterize empirically the very high level of sovereign bond CDS spreads relative to historical default data, and we show that this discrepancy is more severe for bonds with higher ratings and shorter maturities. Second, we build a model with the new ingredient of information frictions and show that it explains a significant fraction of the spreads unexplained by default risk.


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