Although the global financial crisis hit most of the advanced economies in 2008-09, the situation in the Eurozone deteriorated mostly at the turn of 2009 and 2010 when the newly elected Greek government discovered and announced the massive hidden government deficits, which caused a surge in interest rates on Greek sovereign bonds. The sudden rise in Greek borrowing costs was soon to be observed in sovereign interest rates in other southern European countries (Figure 1), pushing some of these countries to apply for international bailouts.
The simultaneous and rapid increase in spreads on sovereign bonds within the Eurozone constitutes a major threat to the survival of the monetary union; and it therefore gets widely discussed among economists (see, among many Vox columns, Corsetti and Müller 2011, Manasse and Zavalloni 2012). Nevertheless, the theoretical mechanism behind the simultaneous surge in sovereign borrowing costs is not yet well understood.
Figure 1. Development of spreads in interest rates on sovereign bonds (as compared to German bonds)
After the introduction of the euro, the interest rates on government debt in the EMU member countries converged to low levels that were previously reserved for the sovereign bonds of core AAA-rated countries, such as Germany. The borrowing costs of the peripheral countries not only decreased, but also became insensitive to fiscal fundamentals in respective countries (e.g. Bernoth et al. 2012, Aizenmahn et al. 2013).
The period of homogenous and low sovereign interest rates ended with the onset of the Greek crisis and the discussions concerning a Eurozone bailout of Greece. The Greek crisis constitutes a turning point in the pricing of sovereign bonds in the Eurozone, as markets started to demand high premia for default risk.
Several studies aim to understand the re-emergence of sovereign debt spreads in EMU. Mink and De Haan (2013) identify the effect of news on the Greek crisis and the bailout on borrowing costs in Italy, Portugal and Spain. Similarly, Ludwig (2014) reports empirical evidence of contagion within the Eurozone sovereign debt markets.
The convergence of interest rates within the Eurozone and the re-emergence of spreads at the time of the Greek crisis constitutes a new puzzle in international macroeconomics.
Bailouts within a monetary union
In a recent paper (Eijffinger et al. 2014), we provide a theory that can account for the puzzling behaviour of spreads. Our key theoretical argument is related to the bailout guarantee – and its limitations – provided by a monetary union.
In our theoretical setting, we explicitly model the endogenous bailout decision of the European Monetary Union. We assume that:
- A country that defaults on its sovereign debt can no longer remain in the EMU, unless it is bailed out;
- The union values each country’s membership and, therefore, suffers a loss if a country exits; and
- The marginal loss associated with allowing a country to leave the union is highest if that particular country is the first to leave (first-exit effect).
This means that the union desires to stay as a whole with all of its members. However, once the first country is gone, letting a second country default and leave the union is not that costly anymore.
Our theoretical mechanism implies endogenous bailout guarantees for members of the currency union. A bailout guarantee for a risky country reduces the interest rates on its sovereign debt, since investors expect their losses to be partially covered by the bailout funds of the monetary union.
The implicit bailout guarantees can explain the convergence of borrowing costs at the time of the introduction of the euro.
The decision process on a potential bailout looks different in the case of an untroubled – yet risky – country (such as Portugal) after a troubled union member (e.g. Greece) ends up at the door of the currency union applying for an actual bailout. From this moment on, any additional bailout decision will need to be considered simultaneously with the first one. Because the first-exit premium is now divided between several countries, the maximum bailout that can be granted to each individual country decreases. This leads to the contagion of sovereign default risk to those countries with sufficiently high government debt levels.
Contagion, therefore, works in the form of bailout guarantees being taken away. This mechanism translates into sudden increases in borrowing costs for initially fiscally sound countries.
We claim that this mechanism was at play at the onset of the Greek crisis, when several southern European countries experienced surges in the interest rates on sovereign bonds.
Replicating the Portuguese experience
We introduce the theoretical framework into a standard small open economy DSGE model with two additional features. First, sovereign default is modeled as a random event with the use of fiscal limits (see Bi 2012). Second, we incorporate a sovereign risk channel that transmits movements in sovereign interest rates into domestic private interest rates (see, for example, Corsetti et al. 2014).
We calibrate the model to match the key moments that we observe for Portugal in the period from 1998 to 2012.
Despite its relative simplicity, the model performs quite well in replicating the main macroeconomic variables, such as interest rates, GDP and employment. It predicts a sharp and lasting recession in Portugal following contagion from the Greek crisis. In the simulations, the recession is accompanied by a deep and long fall in employment.
The results from our theoretical as well as quantitative analysis advocate the strict coordination of fiscal policies within currency unions. The model shows that a no-bailout policy within a monetary union cannot be credible and, hence, needs to be replaced by an improved set-up.
Another implication is the economic importance of statements made by politicians and policymakers. Since in reality the value of the first-exit premium is not publicly known, any statement made by a political leader within the monetary union about granting support may influence the public perception of the value and change the borrowing costs of risky governments.
In fact, it might be argued that the ECB president Mario Draghi used exactly this power on 26 July 2012 when he made the pledge that “the ECB is ready to do whatever it takes to preserve the euro”. Therefore, negative statements made by other European leaders may have the opposite effect and contribute to international debt problems.
Aizenmahn, J, M Hutchison and Y Jinjarak (2013), “What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk”, Journal of International Money and Finance 34: 37-59
Bernoth, K, J von Hagen and L Schuknecht (2012), “Sovereign risk premiums in the European government bond market”, Journal of International Money and Finance 31: 975-995
Bi, H (2012), “Sovereign default risk premia, fiscal limits, and fiscal policy”, European Economic Review 102: 161-166
Corsetti, G, K Kuester, A Meier and G Müller (2014), “Sovereign risk and belief-driven fluctuations in the euro area”, Journal of Monetary Economics, 61(C): 53-73
Corsetti, G and G Müller (2011), “Sovereign risk, macroeconomic instability”, VoxEU.org, 12 August.
Eijffinger, S, M Kobielarz and B Uras (2014), “Sovereign debt, bail-outs and contagion in a monetary union”, CEPR Discussion Paper 10459.
Ludwig, A (2014), “A unified approach to investigate pure and wake-up-call contagion: Evidence from the Eurozone’s first financial crisis”, Journal of International Money and Finance 48: 125-146
Manasse, P and L Zavalloni (2012), “Contagion in Europe: Evidence from the sovereign debt crisis”, VoxEU.org, 25 June.
Mink, M and J de Haan (2013), “Contagion during the Greek sovereign debt crisis”, Journal of International Money and Finance 34: 102-113