The European debt crisis had a long-lasting negative economic impact on European economies. The debt crisis resulted from the financial crisis in the United States which started with the collapse of the investment bank Lehman Brothers on 15 September 2008. The financial crisis came as a shock because it was not anticipated by policymakers and professionals. It caused a surge in debt levels, high unemployment and a sharp decline in economic growth. The crisis pushed several countries at the edge of bankruptcy as they were unable to cover their interest payments and roll over their government debt. The most severely affected countries included, Portugal, Ireland, Cyprus, Greece, and Spain. The precise causes underlying the debt crisis in Europe varied across countries. For some, the origin was traced back to a housing bubble, the currency union or excess government spending. During the height of the debt crisis, the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Commission (EC), which formed the Troika, proposed structural adjustment programs which were to be implemented in the crisis countries. Many of the structural reforms were directly tied to financial support and made the financial support conditional on the implementation of the suggested measures. At the beginning of 2010, the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) were created to provide credit to crisis countries to close the refinancing gap. At the start of the crisis the ECB had aggressively lowered interest rates. Moreover, Mario Draghi, the head of the ECB, announced on 6 September 2012 to “do whatever it takes” to save the Euro. Additionally, the ECB started the Outright Monetary Transactions (OMT) program in which bonds of Euro member states were purchased in the secondary sovereign bond market. In July 2014, Portugal and Ireland were able to exit the bailout programmes after economic recovery. However, many countries continue to have high debt levels. This raises the question of whether or not the European debt crisis has been solved. This paper first investigates the dynamics which triggered the European debt crisis. Second, the paper applies a model framework to analyse the role of risk perception and interest payments. Finally, it discusses if the debt crisis is over and highlights policy implications.
2. European Debt Crisis
The yield on government bonds can be used as a measure of sovereign risk as it incorporates a default premium (Bodie, 2011). The interest payments can be considered as a compensation to investors for holding the sovereign debt. For sovereigns, the yield determines the cost of borrowing in the market. The analysis of the evolution of the 10-year bond spreads of European sovereigns is key to understand the debt crisis. Figure 1 shows that after the adoption of the Euro as a common currency, there was a strong convergence of 10-year bond yields among European economies. Yields remained at the same level until the breakout of the crisis. This suggests that investors were willing to lend countries such as Greece and Portugal money at the same rates as France or Germany, despite the fundamental economic differences. With the breakout of the crisis, market perceptions about the riskiness of sovereign changes and the yields started to diverge. Investors suddenly started to attribute higher risk to these bonds and required higher interest payments. This lead to a vicious cycle for some countries because they were unable to refinance their debt at higher rates. One of the indirect policy outcomes of the ECB’s monetary policy is the convergence of the 10-year bond yields before and after the crisis (Ehrmann et al., 2007; Praet, 2017). It is interpreted as a sign of the ECB’s monetary policy credibility in financial markets. In theory, any rational and risk neutral investor requires a compensation for the risk of his investment. The lender’s risk hypothesis states that the interest payments on government bonds must equal the risk-free rate divided by the probability of repayment (Lebre de Freitas, 2017). The arbitrage condition must be satisfied at any point in time. Ceteris paribus, investors require a higher compensation as the probability of repayment decreases.
3. First Period – Europe before the crisis
The dynamics of the European debt crisis can be analysed within a two-period model (Lebre de Freitas, 2017). Therein, the period before the breakout of the crisis can be understood as the first period in which the debt-to-GDP levels of most of the European countries were at stable levels. This was also true for countries which were hit the most by the crisis. For instance, Figure 2 shows that Portugal, Spain and Greece had a debt-to-GDP ratio of 68.4%, 35.5% and 103.1% respectively. During this period, the credibility of all European economies in the debt markets was high as they were perceived to be solvent. The years up to 2008 can be considered as a virtuous cycle in which high credibility and market confidence made it possible for European governments to refinance them cheaply while they continued to invest. In some cases, the primary balance was negative because governments spent more than their tax revenues. Figure 3 shows, for example, that Portugal, Greece and Germany had primary deficits whereas Spain and Italy had surpluses. However, the total government deficit in period 1 is not the decisive factor in determining the probability of repayment. It is determined by the revenue which the government has available to repay its debt in period 2. This revenue is the difference between the tax revenue and government minimal expenditure . Therefore, rational and risk neutral investors continued to buy bonds, because they believed that the government can pay its debt obligations in the subsequent period, . This analysis makes clear that investors who bought European government bonds regarded them as a safe conglomerate and formed expectations about period 2 in which the European sovereigns were always solvent . Therefore, they were willing to lend at such low rates. This led to a “good” equilibrium which was stable. Sovereigns had the ability to repay debt because the low interest rates and the credibility of a high probability of repayment were reinforcing each other.
4. Second Period – Europe after the crisis
With the breakout of the debt crisis in 2009, debt-to-GDP levels of many European sovereigns sharply increased and interest rates on the 10-year government bonds started to diverge. In fact, the financial crisis in the USA can be seen as an external shock. The economic downturn put additional pressure on European economies and market expectations turned pessimistic. In 2010, the three big credit rating agencies started to downgrade many of the weaker European economies including Greece, Portugal and Spain. This reflected the high-risk perception in the market and the credit downgrades were strong signals to the market that the probability of repayment dropped. Thus, the sudden shock led to a new “bad” equilibrium with a lower probability of repayment and high interest rates. However, this exacerbated the situation for sovereigns to roll over their debts and triggered a vicious cycle. Higher interest payments made it more difficult to cover interest payments and roll over debt to the next period which in turn led to a higher probability of default. For example, Portugal’s and Greece’s interest rate on their debt rose to 12.81% and 29.24% respectively in February 2012. In the model, this “bad” equilibrium is not stable. It leads to downward spiral dynamics in which small open economies are unable to restore credibility by themselves once they experienced heavy financial distress. Another problem during crisis situations is coordination failure. As creditors start to demand higher compensation, they increase the sovereign’s risk of default. Because investors are relatively small and dispersed, it is hard to coordinate common actions. By demanding lower compensation, they could increase the probability of repayment and move back to the “good” equilibrium. However, investors did not have any incentives to do so but continued to impose a negative externality on other creditors. Yet, the ECB and the EU delivered coordinated policy responses by guaranteeing the Euro as a currency and providing financial support. In fact, the EU created the EFSF in 2010 and EFSM in 2011 to close the financing gap for member countries in need. The idea of these policy responses was that crisis countries could overbridge the crisis periods in which market confidence was low and access to finance more difficult. These financial measures helped to restore credibility in the market which sent out signals about the higher probability of repayment. Investors were again willing to provide financing at lower cost because these actions were credible signals about the sovereigns’ solvency.
5. Policy implications
The analysis shows that high debt levels were not the cause of the European debt crisis but rather the result of it. The two-period model stresses the importance of credibility, confidence and expectations in financial markets. Almost 10 years after the financial crisis and thanks to numerous policy measures, European economies have stabilized themselves. European 10-year government bond yields have started to converge quickly since 2013 and remained on average yield levels of 1.4% in 2017. Policymakers should analyse the current equilibrium in the same two-period model framework. There exist, however, remarkably differences in the pre-crisis status quo. The debt levels have skyrocketed for countries like Portugal, Greece and Spain because fewer tax revenues were collected, and private debt was bailed out during the crisis (Klein, 2015). The current situation can be seen as countries having reached their maximum feasible debt level . In the model, a unique equilibrium is obtained. Even though this equilibrium is stable, it is highly sensitives to changes in the fundamental factors. At this equilibrium, any small increase in the debt levels, would trigger the vicious cycle leading to default. In addition, changes in the risk-free interest rate would have the same effect.
This has strong implications for policy-making in the current low interest environment. As the ECB’s OMT program will gradually be reduced, a rise of the central interest rate becomes more likely. Because of the lender’s risk hypothesis, investors would require higher interest payments. This raises the question about the sustainability of sovereign debt levels in the EU. So far, many of the long-term structural challenges remain unsolved. With high debt levels, the fear of defaults in the future will become apparent once economic growth slows again and no European crisis resolution mechanism is implemented. In a future crisis scenario, the fear of bank runs and contagion remain. Current discussion surrounding the sustainable level of Italy’s debt level show that expectations and credibility in the market play a central role. The debt crisis has shown, however, that expectations can change quickly. Slower economic growth or a loss in confidence may quickly reverse the achievements of the last years and trigger another self-fulfilling debt crisis. Overall, it cannot be concluded that the European debt crisis is over. Too many uncertainties, imbalances and frictions remain. Policymakers need to develop long-term solutions to tackle these major structural challenges and reduce debt levels through economic growth and balanced budgets. Crisis resolution mechanisms are needed to create long-term confidence, to build a more resilient and sustainable framework for the future in the EU.
Author:Paul-Leonard Glöckner (30730)
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Figure 1. Long-term interest rate for convergence purposes – 10 years maturity
Source: own calculations based on data from the European Central Bank Statistical Data Warehouse.
Figure 2. General government gross debt-to-GDP ratio [%]
Source: own calculations based on data from the IMF World Economic Outlook October 2017.
Figure 3. Primary balance to GDP ratio [%]
Source: own calculations based on data from the Public Finances in Modern History Database.