Current works and working papers

We develop an optimal design of a Financial Stability Fund that coexists with the international debt market. The sovereign can borrow defaultable bonds on the private international market, while having with the Fund a long-term contingent contract subject to limited enforcement constraints. The Fund contract does not have ex-ante conditionality, but requires an accurate country-specific risk-assessment (DSA), accounting for the Fund contract. The Fund periodically announces the level of liabilities the country can sustain to achieve the constrained efficient allocation. The Fund is only required minimal absorption of the sovereign debt, but it must provide insurance (Arrow-securities) to the country. Furthermore, with the Fund all sovereign debt is safe independently of the seniority structure; however, for the Fund, seniority may require a greater minimal absorption than a \emph{pari passu} regime. We calibrate our model to the Italian economy and show it would have had a more efficient path of debt accumulation with the Fund.

Countries must comply with loan conditions in order to receive official-sector financial support. After constructing a unique dataset with condition-level information for euro area financial assistance programmes, we demonstrate the importance of creditors’ discretion on the timing and content of assessments in boosting compliance with conditionality: by choosing to assess a relatively small number of conditions and by delaying the assessments of others until conditions could be fulfilled. As a result, compliance with a relatively small subset of conditions is sufficient to satisfy creditors and trigger disbursements, especially fiscal measures aimed at the immediate stabilisation of public finances and those with explicit numerical targets, with structural conditions playing a minor role. Such creditors’ filtering process can be efficient in some cases — e.g. when new information reveals the irrelevance of some conditions or when state-contingencies need to be taken into account. Nevertheless, the large number of conditions is a signal of lack of commitment, opening the door to strategic selection, time-inconsistent decisions (e.g. redraftings) and inefficient ‘wait and see’, delays aimed at minimizing negative assessments. In the second Greek programme the lack of independence between the creditor’s decision to assess and the debtor’s decision to fulfil an assessed condition is evidence of inefficient collusion; however, foreseen disbursements and spread market pressures enhanced assessments and compliance, respectively. We extract lessons, from our evidence, for a better design of the conditionality-compliance process.Read more

We develop a model of a Financial Stability Fund (Fund) for a union of sovereign countries. By contract design, the Fund never has expected undesired losses while, being default-free, a participant country has greater ability to borrow and share risks than using sovereign debt financing. The Fund contract also provides better incentives for the country to reduce endogenous risks. These efficiency gains arise from the ability of the Fund to offer long-term contingent financial contracts, subject to limited enforcement (LE) and moral hazard (MH) constraints as part of the contingencies. We develop the theory (welfare theorems, with a new price decentralization) and quantitatively compare the constrained-efficient Fund economy with an incomplete markets economy with default. In particular, we characterize how prices and allocations differ, when the two economies are subject to exogenous productivity and endogenous government expenditure shocks. In our economies, calibrated to the euro area ‘stressed countries’, substantial welfare gains are achieved, particularly in times of crisis. The Fund is, in fact, a risk-sharing, crisis prevention and resolution mechanism, which transforms participant countries’ defaultable sovereign debts into union’s safe assets. In sum, our theory can help to improve current official lending practices and, eventually, to design an European Fiscal Fund.Read more

We study the optimal designs of a Fiscal Union with independent currencies and of a Monetary and Fiscal Union (Currency Union) and their relative performance. We derive the optimal fiscal-transfer policy in these unions as a dynamic contract subject to enforcement constraints, whereby in a Currency Union each country has the option to unpeg from the common currency, with or without default on existing obligations. Our analysis shows that the lack of independent monetary policy, or an equivalent independent policy instrument, limits the extent of risk-sharing within a Currency Union. It also shows that  the optimal state-contingent transfer policy implements a constrained efficient allocation that minimises the losses of the monetary union; that is, the fiscal transfer policy is complementary to monetary policy.  At the steady state, welfare is lower than in a Fiscal Union with independent monetary policies. However, with nominal rigidities and only one shock disrupting consumption, risk-sharing reduces the cost of losing independent monetary policy and, as a result, the welfare loss for having a Currency Union can be quantitatively very small. Nevertheless, this almost-equivalence welfare result breaks down when, for example, there is another shock disrupting consumption: the Fiscal Union with independent currencies can confront both shocks separately, which can not be done with the constrained efficient complementary mix in a Currency Union. Importantly, these results — in particular, the lower value of the Currency Union — change when there are trade costs associated with independent monetary policies, unless these costs are (counterfactually) negligible. If they are not, Currency Union dominates Fiscal Union. In the latter the constrained efficient fiscal-transfers policy, accounts for these costs, limiting the extent of risk-sharing, while efficiently assigning the trade costs associated with the transfers. Read more