1. Sovereign debt and multiple equilibria
Steinar Holden
Department of Economics, UiO
ECON 4325
3 May 2013

3. Lower interest rates for EMU countries in 2099

4. But not in 2011 – what had happened?

5. Countries without national central bank are more vulnerable for debt crises
Estimate – percent of GDP
Budget balance
Primary balance
Gross debt
Net debt
Great Britain
-8.8
-5.6 81 73
Spain
-6.1
-4.4 67 56
Kilde: IMF Fiscal Monitor September 2011
In spite of this, Great Britain has been borrowing at 2.5 % interest rate, and Spain at over 5%

6. Debt in ”foreign currency” – without national central bank

7. Total financing needs 2012 maturing debt green, budget deficit blue

8. Two equilibria Good equilibrium Bad equilibrium
The market expects the debt to be paid
The interest rate is low, and the debt can be paid
Bad equilibrium
The market fears that the debt will not be paid
The interest rate becomes so high that debt is not paid
Self fullfilling expectations can give rise to a liquidity crisis => vast costs
The central bank can buy government bonds
Bad equilibrium can be avoided

9. Central banks buy govt debt

10. Fiscal policy and the financial crisis

12. The Walter’s effect – monetary policy in a monetary union
The same nominal interest rate prevails throughout the EMU
A country with a booming economy will have higher wage and price growth
Lower real interest rate will stimulate the boom
A country in a downturn will have lower wage and price growth
Higher real interest rate will amplify the downturn
Unavoidable destabilizing mechanism

13. Trade balance in the euro area

15. Increasing public debt in advanced economies