A matter of confidence - Self-Fulfilling Sovereign Debt Crises and Bailouts in the Eurozone

Sammanfattning: This thesis analyzes the influence of self-fulfilling mechanisms and potential bailouts on the current sovereign debt crisis in the Eurozone. For this purpose we develop a dynamic stochastic general equilibrium model that extends previous self-fulfilling debt crisis models by (i) incorporating two different players, a single country and the aggregated Eurozone countries, and (ii) including the possibility of a bailout after a default. We show that the debt levels of most European countries are inside a critical interval, called the crisis zone, which makes them vulnerable to a self-fulfilling debt crisis. Furthermore, we demonstrate that bailouts may mitigate self-fulfilling mechanisms. However, bailouts also provide incentives, particularly for smaller countries, to raise debt levels up to a certain threshold that eventually leads to a default. Our findings also rationalize why the EU has bailed out Greece and why smaller countries, such as Portugal, Greece and Ireland, continue to raise their debt levels.