Interdependence of Fiscal Debts in EMU

We use an overlapping generations model to show that a bail-out is the optimal response to a fiscal crisis when the level of integration in a Monetary Union is high and the departure from Ricardian equivalence is significant. As it may not be optimal expost, the no bail-out rule is not credible ex-ante. To make it credible, one would have to look for arrangements that make the cost of one country defaulting sufficiently small, such that it does not impose a risk to the viability of the whole Monetary Union. One way to do that that we exploit is by reducing the relative size of the individual fiscal authority (from national to regional, for example).

Keywords: Debt Default, Monetary Union , Bail-Out.

JEL Classification: E62, F33.

Working paper no. 309