The Sovereign Debt Crisis in Europe: How to Move from Bad to Good Equilibrium?

Abstract

We develop a stylised model for public-debt and growth dynamics with two equilibria, a “good” and a “bad” one. The “bad equilibrium” is characterised by the simultaneous occurrence, and adverse feedbacks between, high and growing fiscal deficits and debt, high risk premia on sovereign debt, slumping economic activity and plummeting confidence, whereas a “good equilibrium” is characterized by stable growth and debt and low risk premia. We believe the southern euro area countries are caught in a bad equilibrium and use this framework to identify policies that can help them to recover. The analysis shows that despite some output loss in the short run fiscal consolidation can help these countries escape from the bad equilibrium trap. More broadly, we find that a combination of financial backstops, structural reform and fiscal consolidation is most effective in helping these countries getting onto a sustainable path (JEL codes: E62; C33; C62).