Analysis of the seeds of the debt crisis in Europe

Abstract

This paper presents an analysis of the seeds of the recent debt crisis that occurred in the Eurozone area using a variant of Fleming and Stein [2004. Stochastic Optimal Control, International Finance and Debt. Journal of Banking and Finance, 28: 979-996] model. This model has two risk drivers arising from uncertainties in the return on capital and the effective rate of return on net foreign assets. Given the risk drivers, we model the net worth value process of an economy under a stochastic setting and show that opening to the rest of the world by pursuing the growth maximizing leverage strategy is better than remaining closed, as that strategy enhances the growth of the net worth process. Second, we provide an extra condition to show when the excessive leverage poses a threat to the sustainable growth of an economy. In this way, we improve the model introduced by Fleming and Stein as a signal of possible debt crises. Finally, we conduct an econometric analysis for the group of countries considered under this study, and show that there is a long-run relationship between the capital stock and the total external debt justifying the use of the structural model we employ.