The 2012 eurozone crisis and the ECB’s OMT program: A debt-overhang banking and sovereign crisis interpretation

Abstract

This paper develops a model that accounts for the main features of the eurozone crisis and studies the effect of a program of sovereign-debt purchases carried out by a central bank partly owned by the foreign sector. In the model, bank lending is distorted by debt overhang, banks hold sovereign debt, and the government taxes output and guarantees banks’ liabilities. At the height of a crisis, there is uncertainty about whether the crisis is driven by self-fulfilling expectations (SFEs) or by weak economic fundamentals. A potentially unlimited program eliminates an SFEs-driven crisis, but can generate financial losses and moral-hazard distortions—adding conditionality avoids these losses and distortions.