The dynamics of sovereign debt crises in a monetary union

Inspired by the European debt crisis of 2010, this paper provides a theoretical framework to analyze the dynamics of sovereign debt crises in a monetary union. I assume that there is a maturity mismatch between the short maturity debt of a country and the long horizon flow of tax revenues, i.e., the need for countries to roll over their debt. A debt crisis can ensue due to doubts about the future ability and willingness for a country to keep rolling over its debt. A monetary union is a collection of such countries with a tragedy-of-the-commons dilemma regarding some common institution, such as a common currency: the default in one country also hurts the other countries in that union, creating an incentive for mutual assistance. Several issues will be addressed. A mechanism for contagion will be proposed and analyzed. The scope for mutual assistance and its ability to prevent a member default will be investigated. Trade offs regarding the participation of the private sector in such rescue operations will be discussed. Implications for the moral hazard on member countries to pursue fiscally prudent policies will be drawn.