This article is co-authored by Jacopo Carmassi, Fellow of the Wharton Financial Institutions Center, and Stefano Micossi, Director General of Assonime, the Association of Joint Stock Companies incorporated in Italy, via VoxEU.org.
As the recent austerity measures can testify, Europe’s leaders are acutely concerned about government debt. This column tracks policy announcements from the start of the Eurozone crisis in December 2009, arguing that governments may have contributed to turmoil with their public display of confusion – ultimately undermining credibility. But if Eurozone governments show unity of purpose, this credibility can be restored.
Despite multiplying good news from the real economy, the past six months have been the most trying times for the euro – certainly the most testing since the height of the financial crisis in late 2008. Mounting doubts concerning the sustainability of sovereign debts and the fragility of Eurozone banks have pushing spreads over the German bund rates to unprecedented heights (Eichengreen 2010).
The sustainability of sovereign debts is a serious issue that must be confronted. The combination of large public sector deficits to support economic activity and persistently weak private demand raises questions of debt sustainability in the medium term (Fatás and Mihov 2010).
Financial markets, however, seem to have blown these fears out of proportion, leading to a full scale confidence crisis. After all, Greece’s public debt is a tiny proportion of Eurozone GDP and banks’ capital and there is no serious grounds to believe that another Eurozone member can become insolvent any soon.
Loose lips sink markets?
Indicative evidence presented here may indicate that politicians’ public disagreements and careless statements at critical junctures may have added oil to incipient fire. By creating the impression that domestic political interests would take precedence over orderly management of the Greek debt crisis, they raised broader doubts on their ability to address fundamental economic divergences within the area, which are the real source of debt sustainability problems in the medium term.
Our chart (figure 1) reports daily spreads for ten-year government debt between Germany, on one hand, and Greece, Portugal, Spain, Italy and France on the other. We have also indicated on the chart significant events in coincidence with observed changes in spread patterns (events are indicated with numbers referring to the event list in the appendix).
Figure 1. 10-years government bonds spread versus German bund for selected Eurozone countries, December 2009-June 2010 (in percent)*
* Daily data. Especially bad news in red. Source: Financial Times on Thomson Reuters.
As may be seen, up until the beginning of February 2010 by and large the Greek crisis is just that, a Greek crisis, reflected in the widening spread relative to all other government paper. But in the ensuing weeks all spreads start to widen and in the period of most acute instability in April and May all spreads follow similar patterns both in their upswings and downswings – albeit in different scale. Markets were somehow coming to believe that government insolvency would spread from one country to another, leading eventually to a banking crisis.
