International Spillovers and Bailouts.

This article examines how sovereign default in one country generates cross-country macroeconomic spillovers through internationally diversified sovereign debt holdings, influencing the equilibrium occurrence and design of bailouts. It develops a two-country model distinguishing a "safe" country with full debt repayment commitment and a "risky" country prone to default, where entrepreneurs' financial wealth affects production. The study shows that creditor countries prefer external bailouts to domestic bailouts because external bailouts are cheaper, as they mitigate macroeconomic losses in both debtor and creditor countries, enabling higher debt repayment with smaller transfers. Anticipated bailouts increase borrowing incentives, which can be welfare-improving ex ante by correcting under-borrowing externalities due to international financial integration. Calibrated to European data, the model replicates key features of the 2011–2013 European debt crisis, highlighting that financial expansions in safe countries (e.g., Germany) can trigger or amplify debt crises in risky countries (e.g., GIIPS) through portfolio diversification effects. The findings suggest that committing not to bailout may reduce welfare for both creditor and debtor countries, challenging the view that bailouts necessarily induce harmful moral hazard.