Sunday, May 5, 2013

LSE Study: Self-Fulfilling Crisis of Eurozone Sovereign Debt

In an empirical study on Eurozone sovereign debt published at LSE and at CEPS, an EU-financed economic policy think tank, has found definitive evidence of the fragility of Eurozone-member-nation debt vis-a-vis non-eurozone EU debt. In particular, the study finds that aggressive growth in Eurozone sovereign bond spreads since 2010 have been generally disconnected from key market fundamentals. Just outside of the Eurozone meanwhile, standalone countries have faced a much lower degree of sovereign bond volatility, despite having similar Debt-to-GDP ratios as their Eurozone counterparts.

What this all means is that the credibility and competence of the European institutions behind the Euro, are being called into question by the market, as panicky investors flee the Eurozone, and countries that are hit by the resulting liquidity crises are forced apply stringent, recession-causing austerity measures. While Greece had indeed accumulated an unsustainable Debt-to-GDP ratio, other Eurozone countries that were hit by the crisis had Debt-to-GDP levels, which were certainly not worse than the of the US and the UK. What is needed, LSE argues, are pro-liquidity policies aimed at preventing the spread of sovereign debt liquidity polices from one country to the next. Exactly the sort of the thing Merkel and her henchmen are against.

The study's main author, Professor Paul De Grauwe, a former Belgian senator, is widely considered to be Belgium's most renowned economist 

We test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self -fulfilling liquidity crises than in stand -alone countries. We find evidence that a significant part of the surge in the spreads of the PIGS countries in the Eurozone during 2010-11 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, an d was the result of negative self -fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the Eurozone into bad equilibria. 

We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand -alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries. 

Paul De Grauwe is a Professor in European Political Economy and head of the European Institute at the London School of Economics. He is also professor emeritus in international economics at KU Leuven and former member of the Belgian Federal Parliament.

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