M-RCBG Associate Working Paper No. 186
When to Hold ’Em, When to Fold ’Em: Analyzing Multiple Equilibria Models of Sovereign Default
2022 John Dunlop Undergraduate Thesis Prize Honorable Mention
In a monetary union, countries issue debt in the common currency of the union, which is not guaranteed by the country itself. Thus, there exists a default risk for countries in a monetary union that does not exist in standalone nations with an independent central bank which can guarantee solvency in a crisis. This fundamental feature (or flaw) of a monetary union has been argued to lead to increased fragility and susceptibility to self-fulfilling solvency crises. Building on prior research, this paper attempts to validate this theory empirically through comparing bond spreads, which are used as both an indicator of investor concern and a proxy for default risk, of countries in a monetary union and those that are “standalone,” or have an independent banking system. In doing so, this paper provides a more nuanced understanding of multiple-equilibria models of sovereign default through testing additional components of sovereign bond spreads, notably those related to investor risk tolerance. The empirical results indicate that countries in a monetary union are vulnerable to self-fulfilling crises of confidence at periods of heightened market instability, and that countries in monetary unions are “punished” by markets for having high net foreign debt more so than standalone nations, both of which ultimately support the fragility hypothesis.