06 November 2013

IMF Working Paper: Sovereign Risk and Belief-Driven Fluctuations in the Euro Area

Sovereign risk premia in several euro area countries have risen markedly since 2008, driving up credit spreads in the private sector as well. The IMF proposes a New Keynesian model of a two-region monetary union that accounts for this "sovereign risk channel".

Authors: Giancarlo Corsetti, Keith Kuester, Andre Meier and Gernot Müller

In this paper, the authors analyse the implications of sovereign risk for macro-economic stability in a currency union, using a stylised monetary model calibrated to the euro area. Their focus is on instability caused by self-fulfilling expectations of an economic downturn, i.e. situations where the equilibrium is not uniquely determined. As is well understood, such equilibrium indeterminacy can arise if policy rates remain constant for an extended period of time, for example, due to the zero lower bound (ZLB). The authors analyse the conditions under which a sovereign debt crisis in one part of the currency union exacerbates this risk of indeterminacy, making the entire union vulnerable to a belief-driven deflationary downturn.

Rising risk premia on government debt tend to drive up credit spreads in the private sector. When the central bank is constrained by the zero lower bound (ZLB) on policy rates, these spillovers from public to private spreads give rise to a sovereign risk channel that alters the trade-off between fiscal consolidation and support for economic activity. The authors integrate this sovereign risk channel in an otherwise standard New Keynesian two-country model and explore its implications for macro-economic stability in a monetary union.

The authors calibrate the model to key features of the euro area as of mid-2012, distinguishing government debt levels across stressed and other economies. They show formally how the sovereign crisis in the stressed economies may threaten macro-economic stability in the euro area as a whole, by exacerbating the risk of self-fulfilling expectations of a deflationary downturn.

This result rests on the assumption that i) monetary policy is constrained by the ZLB for an extended period; and ii) both sub-groups of euro area economies pursue procyclical policies during a recession—a policy scenario that strikes the authors as empirically relevant. By contrast, they also find that a (coordinated) asymmetric fiscal stance that combines procyclical cuts in the stressed (high-debt) economies with countercyclical expansion in the other (lower-debt) countries is conducive to macro-economic stability.

Building on this analysis, the authors consider the potential pooling of sovereign risk, as implied by recent institutional initiatives within the euro area, notably the European Stability Mechanism (ESM) and the ECB’s Outright Monetary Transactions (OMT). Since risk premia increase non-linearly in debt, risk pooling reduces the strength of the sovereign risk channel. Even so, the authors' simulations suggest that pooling per se does not alleviate the threat to macro-economic stability as long as the union-wide fiscal stance remains largely procyclical.

Thus, the most critical aspect of policy coordination turns out to be the interaction between (constrained) monetary policy at the level of the currency union and the cyclicality of fiscal policy in the constituent parts. The limited benefits from debt pooling in their model may be surprising, given the actual stabilisation of financial market conditions in the euro area since the introduction of ESM and OMT. One way to reconcile these observations is to note that the ECB’s OMT framework can be interpreted in more than one way. In particular, its apparent stabilising effects may relate to aspects other than the implicit pooling of government debt which the authors have focused on.

The transmission mechanism the authors analyse in this paper emphasises the adverse effects on current output of expectations of a possible sovereign default in the future. For the sake of tractability, they model the sovereign risk channel using empirically motivated reduced-form relationships between the fiscal outlook and risk premia on public and private debt. As a way forward, a model accounting for endogenous default under imperfect policy credibility might improve understanding of how these relationships are shaped by actual policy trade-offs between distortions caused by taxes and inflation, output stabilisation and (endogenous) default costs. Such an extension of the authors' model could contribute a monetary perspective to recent research (see, for instance, Mendoza and Yue 2012) that examines the endogenous output effects of sovereign debt crises in fully-fledged models of fiscal policymaking. 

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