Saving the Euro: self-fulfilling crisis and the ‘Draghi Put’

European markets for sovereign bonds have been prone to panic as investors fly to safety whenever they think others will. Calvo (1988) had warned of the possibility of multiple equilibria in bond markets; and argued for official action to limit interest rate rises so as rule out a self-fulfilling default equilibrium. Until recently, however, it appeared that the ECB was not able to act as necessary. But in August 2012, the ECB announced a policy of Outright Monetary Transactions which promised intervention to put a ceiling on rates for sovereigns willing to accept further fiscal stringency; and we use Calvo’s framework to illustrate how this policy of a ‘put’ for sovereigns can work. In addition to unilateral action by the ECB, some have proposed the consolidation of sovereign debt into Eurobonds backed by a supranational agency. Specifically, we propose the creation of a Special Purpose Vehicle (SPV) which issues Eurobonds and holds both plain vanilla sovereign debt and newly created state-contingent bonds. This offers, we believe, a desirable complement to the ‘Draghi put’.