Analysis of the seeds of the debt crisis in Europe

This paper presents an analysis of the seeds of the recent debt crisis that occurred in the Eurozone area. We use the model of Fleming and Stein [J. Bank. Financ., 2004, 28, 979-996] for the analysis. 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 introduce a leverage strategy as the control policy for the evolution of the stochastic net worth process. In this way, we are able to obtain a model that is similar to a dynamically traded portfolio. Given this similarity, we then proceed to find the growth optimal leverage strategy and show that opening to the rest of the world under this leverage strategy is better than remaining closed, as that strategy enhances the growth of the net worth process. By referring to the properties of the growth optimal strategy, devised under the continuous-time portfolio optimization literature, we then establish that policy as the limiting case and 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 indication ability of Fleming and Stein as a signal of possible debt crises. This condition translates to no admissible leverage strategy for turning the economy around during a downturn if the fundamentals are not sufficiently favorable. This allows us to examine precisely how excessive risk taking due to over-borrowing is a danger to an economy, and subsequently, we show the indicative evidence via the sample of countries selected for the study.