Sovereign Risk Premium and Divergent Fiscal Policies in a Monetary Union

During the euro area (EA) sovereign debt crisis, lenders in financial markets raised default risk premiums on sovereign bonds issued by countries that were then considered too risky. Among some of these countries (especially Greece), fiscal policy had not been implemented according to good practices. In particular, the lack of fiscal discipline stemmed from pro-cyclical public spending. The (over-) reaction of financial markets translated into a sharp increase in the level of long-term interest rates in crisis-hit countries. Consequently, these countries were confronted with severe difficulties in trying to reduce public indebtedness. Moreover, the cost of borrowing for the private sector increased. In this article, we study the effects of asymmetric shocks causing a rise in the sovereign risk premium of one country of a monetary union. We analyze their effects on the domestic country (the one hit by the shock) and the spillovers on the rest of the union (RoU). To do so, we build an open monetary union DSGE model in which member countries are different from one another with regard to the degree of fiscal discipline (pro-cyclical versus counter-cyclical fiscal behaviour). We show that such a model is suitable to explain the mechanisms underlying divergent macroeconomic performance across EA countries after the Greek sovereign debt crisis.