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Mispricing of sovereign risk and multiple equilibria in the Eurozone

Economists now agree that markets were wrong in placing the same risk premium on Greek bonds as on German bonds. But this column adds that today the same markets are also wrong in overestimating the risk that the periphery countries will default. Policymakers looking to calm such skittish markets should take note.

It is widely acknowledged that Eurozone financial markets were systematically wrong from 2001 to 2008 when they charged the same risk premium on Greek and German government bonds despite huge differences in their debt-to-GDP ratios.

Today, the same markets are applying huge spreads on Greek and other Eurozone government bonds. Many economists view today’s spreads as correct. But why – if markets were systematically mispricing risks from 2001 to 2008 – should we believe these same markets have suddenly found the truth? (See Attinasi et al 2010 on this site for how quickly the spreads widened.)

From underestimating spreads to overestimating spreads

In a new paper (De Grauwe and Ji 2012) we argue that financial markets have not suddenly found the truth. Since the start of the sovereign debt crisis they have been making errors in the other direction. In other words, they are now overestimating risks. Using a panel data model, we find evidence that a large part of the surge in the spreads of the periphery countries between 2010 and 2011 was disconnected from underlying increases in the debt-to-GDP ratios and current-account positions, and was the result of negative market sentiments, even panic, that became very strong starting at the end of 2010.

Figure 1 illustrates this result. It presents pooled time-series and cross-section observations of the relation between the spreads of ten-year government bond rates of Eurozone governments compared with the German bond rate between 2000 and 2011 (quarterly observations). The red line represents the regression line indicating that increasing spreads are associated with increasing debt-to-GDP ratios. This line could be called the ‘fundamental relation’ between spreads and debt ratios. The most striking feature of Figure 1 is that at some point in time the spreads of some countries deviate spectacularly from the fundamental relation. We have circled these points of departure (defined as more than three standard deviations away from the fundamental line). They relate to Greece, Ireland, and Portugal – and they emerge in 2010.

Figure 1. Ten-year government bond spreads and debt-to-GDP ratios of Eurozone countries 2000–11 (quarterly observations)

Source: De Grauwe and Ji (2012); data from Datastream and OECD

We also find evidence that after years of neglecting high debt-to-GDP ratios, investors became increasingly worried about the high debt-to-GDP ratios in the Eurozone, and reacted by raising the spreads. No such worries developed in standalone countries despite debt ratios that were equally high and increasing.

Fragility of sovereigns’ debt in a monetary union

We interpret this evidence as validating the hypothesis formulated in De Grauwe (2011a) according to which government bond markets in a monetary union are more fragile and more susceptible to self-fulfilling liquidity crises. The standalone countries in our sample have been immune from these liquidity crises and weathered the storm without the increases in the spread.

The story of the Eurozone crisis is also a story of systematic mispricing of the sovereign debt, which in turn led to macroeconomic instability and multiple equilibria. During the 2001–08 period the systematic underpricing of the risk in the peripheral countries led to unsustainable booms in real estate and in consumption – that is, until the crash. Since 2010, however, the systematic overpricing of sovereign risk has had the effect of pushing these countries in a self-fulfilling way into bad equilibria characterised by solvency crises and deep recessions (Calvo 1988, Gros 2011, Corsetti and Dedola 2011).

Impact on policy

The systematic mispricing of sovereign debt observed in the Eurozone also has the effect of giving the wrong incentives to policymakers. During the boom years, when financial markets were blind to the sovereign risks, no incentives were given to policymakers to reduce their debts, as the latter were priced so favourably. Since the start of the financial crisis financial markets driven by panic overpriced risks and gave incentives to policymakers to introduce excessive austerity programmes. This panic has now been transmitted to the European Commission that is urging Eurozone countries to intensify budgetary austerity programmes while the Eurozone is moving into a recession – an extraordinary repeat of the 1930s.

To summarise:

  • In a world where spreads are tightly linked to the underlying fundamentals such as the debt-to-GDP ratio, the only option the policymakers have in reducing the spreads is to improve the fundamentals. This implies measures aimed at reducing the debt burden.
  • If, by contrast, there is a disconnect between spreads and fundamentals, a policy geared exclusively towards affecting the fundamentals (ie reducing the debt burden) will not be sufficient.

In that case policymakers should also try to stop countries from being driven into a bad equilibrium.

This can be achieved by more active liquidity policies by the ECB that aim to prevent a liquidity crisis in government bond markets from leading to a self-fulfilling solvency crisis (see Wyplosz 2011 and De Grauwe 2011b on this site).

It should be stressed that:

  • Policy aimed at improving the fundamentals through budgetary austerity and the policy of liquidity provision by the central bank are not substitutes, but complements.
  • When a member country of a monetary union is hit by a liquidity crisis that leads to a disconnect between the spreads and the fundamentals, both policies will in general be needed.

All too often these two types of policies have been seen as ‘either/or’. In fact, in a monetary union conditions can arise in which both types of policies are required.


Attinasi, Maria Grazia, Cristina Checherita, and Christiane Nickel (2010), “What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09?”, VoxEU.org, 11 January.

Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review, 78(4):647-661

Corsetti, GC, and L Dedola (2011), “Fiscal Crises, Confidence and Default. A Bare-bones Model with Lessons for the euro Area”, unpublished, Cambridge.

De Grauwe, P (2011a), “The Governance of a Fragile Eurozone”, Economic Policy, CEPS Working Documents, May.

De Grauwe, P (2011b), “The ECB as a lender of last resort”, VoxEU.org, 18 August.

De Grauwe, P and Y Ji (2012), “Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone”, CEPS Working Documents.

Gros, D (2011), “A simple model of multiple equilibria and default”, mimeo, CEPS

Kindleberger, C (2005), Manias, Panics, and Crashes: A History of Financial Crises, , 5th edition. Basingstoke: Palgrave Macmillan.

Wyplosz, C (2011), “They still don’t get it”, VoxEU.org, 25 October. 

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