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Self-Fulfilling Crises in the Eurozone: An Empirical Test

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  • De Grauwe, Paul
  • Ji, Yuemei
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    Abstract

    This paper tests the hypothesis that 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 (Portugal, Ireland, Greece and Spain) in the eurozone during 2010-11 was disconnected from underlying increases in the debt-to-GDP ratios and fiscal space variables, and 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.

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    File URL: http://www.ceps.eu/system/files/WD%20No%20367%20PDG%20%2526%20YJ%20Empirical%20Test%20Fragility%20Eurozone_0.pdf
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    Bibliographic Info

    Paper provided by Centre for European Policy Studies in its series CEPS Papers with number 7085.

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    Length: 29 pages
    Date of creation: Jun 2012
    Date of revision:
    Handle: RePEc:eps:cepswp:7085

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    1. Arghyrou, Michael G. & Kontonikas, Alexandros, 2012. "The EMU sovereign-debt crisis: Fundamentals, expectations and contagion," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(4), pages 658-677.
    2. Schuknecht, Ludger & von Hagen, Jürgen & Wolswijk, Guido, 2009. "Government Bond Risk Premiums in the EU revisited: The Impact of the Financial Crisis," CEPR Discussion Papers 7499, C.E.P.R. Discussion Papers.
    3. Miguel A. Segoviano Basurto & Carlos Caceres & Vincenzo Guzzo, 2010. "Sovereign Spreads," IMF Working Papers 10/120, International Monetary Fund.
    4. Eichengreen, Barry & Mody, Ashoka, 2000. "Lending booms, reserves and the sustainability of short-term debt: inferences from the pricing of syndicated bank loans," Journal of Development Economics, Elsevier, vol. 63(1), pages 5-44, October.
    5. Guglielmo Maria Caporale & Alessandro Girardi, 2011. "Fiscal Spillovers in the Euro Area," Discussion Papers of DIW Berlin 1164, DIW Berlin, German Institute for Economic Research.
    6. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    7. Eaton, Jonathan & Gersovitz, Mark & Stiglitz, Joseph E., 1986. "The pure theory of country risk," European Economic Review, Elsevier, vol. 30(3), pages 481-513, June.
      • Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc.
    8. Gibson, Heather D. & Hall, Stephen G. & Tavlas, George S., 2012. "The Greek financial crisis: Growing imbalances and sovereign spreads," Journal of International Money and Finance, Elsevier, vol. 31(3), pages 498-516.
    9. Boehmer, Ekkehart & Megginson, William L, 1990. " Determinants of Secondary Market Prices for Developing Country Syndicated Loans," Journal of Finance, American Finance Association, vol. 45(5), pages 1517-40, December.
    10. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
    11. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
    12. De Grauwe, Paul, 2011. "Governance of a Fragile Eurozone," CEPS Papers 5523, Centre for European Policy Studies.
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    Cited by:
    1. Roberto Tamborini, 2012. "Market opinions, fundamentals and the euro-sovereign debt crisis," Department of Economics Working Papers 1210, Department of Economics, University of Trento, Italia.
    2. Westermann, Frank & Steinkamp, Sven, 2013. "On Creditor Seniority and Sovereign Bond Prices in Europe," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79848, Verein für Socialpolitik / German Economic Association.
    3. Gärtner, Manfred & Griesbach, Björn, 2012. "Rating agencies, self-fulfilling prophecy and multiple equilibria? An empirical model of the European sovereign debt crisis 2009-2011," Economics Working Paper Series 1215, University of St. Gallen, School of Economics and Political Science.
    4. Mario Sarcinelli, 2013. "The European Banking Union: Will It Be a True Union without Risk Sharing?," PSL Quarterly Review, Economia civile, vol. 66(265), pages 137-167.
    5. Giovanni Calice & RongHui Miao & Filip Sterba & Borek Vasicek, 2013. "Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps," Working Papers 2013/13, Czech National Bank, Research Department.

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