The recent European debt crisis has hit several peripheral Eurozone countries. Problematic countries, such as Greece, Ireland, Portugal, Spain, and Italy, present high government debt levels and structural economic problems (see for instance Eichengreen 2010 on this site). Financing has become a difficult, sometimes impossible, task for them. Lenders are demanding high interest rates that are unsustainable in the long run. The public in general, and policymakers and economists in particular, have speculated on the reasons why uncertainty remained unsustainably high for these countries until they were forced to ask for a financial rescue, like in the case of Greece, Ireland, and Portugal. In this column we bring a new perspective for these episodes based on very recent empirical results from our research (Luque and Taamouti 2012).
Countries repeatedly return to debt markets to finance themselves, sometimes because of new investment opportunities that demand new financing, others following a Ponzi scheme. But any recurrent increment in government debt levels has been accompanied by higher uncertainty in debt markets, followed by higher interest rates on the countries' ten-year government bonds. In our research paper, we aim to investigate whether the effect of government debt and other fundamentals on economic uncertainty (measured by GDP growth rate volatility) is different before and after the adoption of the euro. Our main finding is that after the introduction of the euro, government debt had a positive effect on the economic uncertainty, whereas this effect was negative before the euro. The other economic fundamentals exhibit less structural change on economic uncertainty before and after the euro. Moreover, the comparison between euro and non-euro countries shows that our results are specific to the euro countries.
Roughly speaking, our main result can be summarised as follows. Before the euro increments in government debt helped decrease economic uncertainty, possibly because government debt was used to rebalance the economy and the risk associated with currency fluctuations could be easily hedged by the country’s own monetary policy. However, after the euro we find that increments in government debt increased the economic uncertainty. One plausible explanation is that after 1999, Eurozone countries lost the monetary policy instrument to manage the interest rates associated with their government debts. Countries could no longer use currency devaluation to change the interest rate on their loans, and thus the profitability of their investments became subject to higher uncertainty.
For a more elaborate economic interpretation of our main result, let us consider a simple economy where government debt is only used for public investment. For simplicity, let us ignore the transfers to households. Government borrowing – or increases in government debt – is associated with two components: (i) the marginal productivity of the public investment using government debt, and (ii) the interest rate that represents the cost of borrowing. On the one hand, if marginal productivity is bigger than the interest rate, then the returns from investing the government debt exceed its cost. In this case, the public investment financed by government debt is profitable and, therefore, there is no uncertainty associated with the borrowing. On the other hand, if marginal productivity is smaller than the interest rate, then the public investment is not profitable. In this case, if there is no mechanism available to reduce the burden of debt, then the fear of default increases uncertainty. However, a country with its own national currency has the flexibility of using its monetary policy to reduce the interest rate – via currency depreciation. Thus, this country has the ability to reduce the uncertainty about the profitability of its public investment by assuring that the marginal productivity exceeds the interest rate.
For Greece, Ireland and Portugal, debt markets maintained their sound whipping until they were forced to ask for a financial rescue – at the moment we wrote this article the possibility of an intervention seems closer than ever for Spain and Italy. Once there is an intervention, the countries have had access to much better financing terms and the international pressure on them was alleviated. The financial packages accompanying the intervention are in fact an alternative mechanism for the euro countries to reduce their interest rates 'artificially'. Such a mechanism can effectively reduce the burden of debt and make government investments profitable. However, these financial packages come together with the loss of sovereignty of economic policies and a painful adjustment for citizens.
Policymakers and the public in general should bear in mind that the adoption of the euro makes Eurozone members subject to higher economic uncertainty whenever they go to debt markets to increase their government debt levels. We believe that this is an interesting stylised fact that could help economists and policymakers in searching for new complementary mechanisms, such as a fiscal and a political union, which can create more flexibility for the Eurozone members and help alleviate the rise in uncertainty.
Eichengreen, Barry (2010), “The euro: love it or leave it?”, VoxEU.org, 4 May.
Luque, Jaime and Abderrahim Taamouti (2012), “GDP Volatility Before and After the Euro: The Evidence”, Working Paper 1221, Carlos III University of Madrid.