On the Brink? Intra Euro-Area Imbalances and the Sustainability of Foreign Debt

Abstract

This paper analyses the role of financial market credibility shocks from the European Monetary Union accession and the European sovereign debt crisis for diverging current account balances and net foreign debt positions in the euro area. Based on a dynamic general equilibrium model foreign debt positions of European crisis countries are shown to have significantly diverged from a sustainable path. Today, high foreign debt positions prove difficult to reverse given appreciated real exchange rates and high real interest rates. Real depreciations in European crisis countries, while necessary for long‐term crisis resolution, further worsen foreign debt sustainability by raising the real value of debt in the short‐term. To prevent a debt–deflation spiral the real interest burden should be reduced and the real value of debt should be capped.