18 January 2012

Paul De Grauwe: Mispricing of sovereign risk and multiple equilibria in the eurozone

After the introduction in Section 1, the paper is organised as follows:

Section 2 looks at the relation between spreads and the debt-to-GDP ratio so as to find out how close this relation is, and how it has changed over time. In section 3, a regression analysis is performed explaining the spreads in the eurozone by a number of fundamental variables. In section 4, structural breaks in these spreads are studied. In section 5, the question is asked whether the bubble-like developments in the spreads is also found in “stand-alone” developed countries. In section 6, a test is developed allowing periods during which spreads get disconnected from fundamentals to be identified. Finally, in sections 7 and 8, the theoretical and policy implications of the paper’s findings are discussed.

Abstract:

The paper finds 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 was the result of negative market sentiments that became very strong since the end of 2010. Evidence is also found 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 were equally high and increasing in these countries.

This evidence was interpreted as validating the hypothesis formulated in De Grauwe(2011), according to which government bond markets in a monetary union are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries.

The paper argues that the systematic mispricing of sovereign risk in the eurozone intensifies macro-economic instability, leading to bubbles in good years and excessive austerity in bad years.

Full paper

© Paul De Grauwe