Indebted We Stand-Examining Debt Restructuring in a Currency Union

Abstract

This study examines the optimality of sovereign debt restructuring alternatives within a currency union. Its results suggest that upfront debt relief works better than extra lending, as the latter runs the risk of breaking up the union. Based on the model of Gali & Monacelli (2008), I adopt a Bayesian approach to calculate posteriors with the Markov Chain Monte Carlo (MCMC) method. I show in the analysis that, given the sovereign debt problem in Eurozone, the Bayesian approach projects an even more worrisome prospect than one would anticipate. Nevertheless, debt relief as a bail-out choice is superior to extra lending primarily because consumption, output and market value of debt are all lower under the latter option. More importantly, compared to debt relief, the lending alternative divides the union further apart. Debt recovery probability, as well as debt yields, fiscal burden, and inflationary expectations, drives debtor countries more away from the creditor ones. Even within the creditor group, extra lending would impose bigger budget hikes on more frugal states, in addition to subjecting larger economies to higher deflationary risks.