Analysis of the Seeds of the Debt Crisis in Europe

The paper involves the analysis of the seeds of the recent debt crisis that occurred in the Eurozone area. For the analysis we use the model of Fleming and Stein (2004). 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 threat to the sustainable growth of an economy. This condition allows us to improve upon the predictive ability of the model introduced by Fleming and Stein (2004).