Paper #1827

Title:

On the optimal design of a financial stability fund

Authors:

Árpád Ábrahám, Eva Cárceles-Poveda, Yan Liu and Ramon Marimon

Date:

March 2022

Abstract:

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.

Keywords:

fiscal unions, recursive contracts, Debt Contracts, partnerships, limited enforcement, moral hazard, debt restructuring, Debt Overhang, sovereign fund

JEL codes:

E43, E44, E47, E63, F34, F36

Area of Research:

Macroeconomics and International Economics

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