On the optimal design of a Financial Stability Fund

By Arpad Abraham, Eva Carceles-Poveda, Yan Liu and Ramon Marimon

http://d.repec.org/n?u=RePEc:nys:sunysb:18-06&r=dge

A Financial Stability Fund set by a union of sovereign countries can improve countries’ ability to share risks, borrow and lend, with respect to the standard instrument used to smooth fluctuations: sovereign debt financing. 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. In contrast, standard sovereign debt contracts are uncontingent and subject to untimely debt roll-overs and default risk. We develop a model of the Financial Stability Fund (Fund) as a long-term partnership with LE and MH constraints. We quantitatively compare the constrained-efficient Fund economy with the incomplete markets economy with default. In particular, we characterize how (implicit) interest rates and asset holdings differ, as well as how both economies react differently to the same productivity and government expenditure shocks. In our economies, “calibrated” to the euro area “stressed countries”, substantial efficiency gains are achieved by establishing a well-designed Financial Stability Fund; this is particularly true in times of crisis. Our theory provides a basis for the design of a Fund – for example, beyond the current scope of the European Stability Mechanism (ESM) – and a theoretical and quantitative framework to assess alternative risk-sharing (shock-absorbing) facilities, as well as proposals to deal with the euro area “debt overhang problem.”

This is an important paper in literature that studies how countries can insure themselves against shocks, under the assumption that markets are currently incomplete or not perfect and that business cycles are costly. It essentially boils down to designing complex securities in a way that very large players can supply them. The political ramifications are daunting.

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