Gambling for redemption and self-fulfilling debt crises

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Springer;Society for the Advancement of Economic Theory (SAET), Economic Theory, ISSN: 0938-2259, Vol: 64, Issue: 4, Page: 707-740

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Juan Carlos Conesa; Timothy J. Kehoe
Springer Nature
Economics, Econometrics and Finance
article description
Before the advent of sophisticated international financial markets, a widely accepted belief was that within a monetary union, a union-wide authority orchestrating fiscal transfers between countries is necessary to provide adequate insurance against country-specific economic fluctuations. A natural question is then: Do sophisticated international financial markets obviate the need for such an active union-wide authority? We argue that they do. Specifically, we show that in a benchmark economy with no international financial markets, an activist union-wide authority is necessary to achieve desirable outcomes. With sophisticated international financial markets, however, such an authority is unnecessary if its only goal is to provide cross-country insurance. Since restricting the set of policy instruments available to member countries does not create a fiscal externality across them, this result holds in a wide variety of settings. Finally, we establish that an activist union-wide authority concerned just with providing insurance to member countries is optimal only when individual countries are either unable or unwilling to pursue desirable policies.