Birds of a feather: separating spillovers from shocks in sovereign default

Abstract

In this paper, I propose a tractable model of sovereign default and the inter-state spillovers emanating from default. A coalition of nations may choose to insure against default, and the behavior of the coalition is used to examine the magnitude of the international spillovers. A voting structure for the coalition is proposed to examine idiosyncratic spillovers. The model is calibrated to the recent Greek Debt crisis to understand the spillovers from a default, and the moral hazard effect of the Troika. I find that spillover effects are large. If the rest of the world defaulted, this would create a loss equivalent to a permanent 9% decrease in government spending. Counterfactual experiments reveal that default would be prevalent without the IMF, suggesting that the own-penalty to defaulting has decreased since the IMF’s creation.