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Fiscal Discoveries and Sudden Decouplings

Luis Catão (), Ana Fostel and Romain Ranciere ()

No 9368, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Default; Eurozone Debt Crisis; Fiscal Gaps; Information Asymmetry; Perfect Bayesian Equilibrium; Pesistence; Sovereign Debt; Volatility (search for similar items in EconPapers)
JEL-codes: E62 F34 G15 H3 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-eec, nep-mac and nep-opm
Date: 2013-02
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