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Title: Fiscal Discoveries and Sudden Decouplings

Author(s): Luís A. V. Catão, Ana Fostel and Romain Rancière

Publication Date: February 2013

Keyword(s): Default, Eurozone Debt Crisis, Fiscal Gaps, Information Asymmetry, Perfect Bayesian Equilibrium, Pesistence, Sovereign Debt and Volatility

Programme Area(s): International Macroeconomics

Abstract: The recent Eurozone debt crisis has witnessed sharp decouplings in cross-country bond yields without commensurate shifts in relative fundamentals. We rationalize this phenomenon in a model wherein countries with different fundamentals are on different equilibrium paths all along, but which become discernable only during bad times. Key ingredients are cross-country differences in the volatility and persistence of fiscal revenue shocks combined with asymmetric information on country-specific fiscal shocks. Differences in the cyclicality of fiscal revenues affect the option value of borrowing and resulting default risk; unobservability of fiscal shocks makes bond pricing responsive to market actions. When tax revenues are hit by common positive shocks, no country increases net debt and interest spreads stay put. When a common negative revenue shock hits and is persistent, low volatility countries adjust spending while others resort to borrowing. This difference signals a relative deterioration of fiscal outlooks, interest spreads jump and decoupling takes place.

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Bibliographic Reference

Catão, L, Fostel, A and Rancière, R. 2013. 'Fiscal Discoveries and Sudden Decouplings'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9368