ECB Policy and Eurozone Fragility - Was De Grauwe Right?

Since the onset of the 2009 Greek debt crisis, the suddenness and magnitude of changes in Eurozone bond yield spreads have sparked off a wide debate among economists regarding the likely causes of the ongoing crises. This debate resurrects two conflicting views of debt crises in the literature. The fundamentalist view is that widening yield spreads reflect serious deterioration in countries' macroeconomic fundamentals, such as debt-to-gdp ratios or current account balances. The multiple-equilibria view contends instead that markets may not always function optimally and therefore, countries may find themselves in multiple separate (and distant) equilibrium conditions without experiencing any major change in fiscal fundamentals. Thus, the decisions of panic-driven investors may lead a country to a crisis that otherwise would not have unfolded. In that respect, the idea that a monetary union lends itself to the devilish effects of self-fulfilling dynamics was originally promoted by Paul De Grauwe who summed it up in the his Eurozone fragility hypothesis. This hypothesis states that by issuing debt in a currency that they cannot control, Euro member states become more vulnerable to adverse investor sentiments and sudden stops in capital inflows and hence, more prone to sovereign debt crises. However, for a sovereign that maintains control over its currency, markets recognize the presence of a central bank that stands ready to inject the necessary liquidity and no one would strategically sell off the government bonds fearing that others would also do so. Thus, a single equilibrium would prevail and the crises would occur only in times of fundamental insolvency, not in times of illiquidity.

Over the last few years, this latter view of the Eurozone crisis has led the European Central Bank (ECB) to take important steps towards accepting the lender-of-last-resort (LOLR) position in the European sovereign debt markets. It was a whole-hearted initiative when, on 27th of July, 2012, the ECB President Mario Draghi announced that the ECB was prepared to "do whatever it takes to preserve the euro". The paper considers this change in policy stance as an ideal laboratory to empirically test De Grauwe's Eurozone fragility hypothesis and shed light on the long-standing theoretical debate between fundamentalists and multiplists by investigating whether the OMT announcement has effectively curbed the self-fulfilling contagion effects in Eurozone debt markets.

The findings suggest that the OMT announcement decreases the overall level and volatility of Eurozone CDS spreads and changes the way markets discriminate among sovereigns towards a more fundamental-based approach. The event-study reveals that the pre-announcement contagion effects from Spain-related news largely recede post-announcement. The residual analysis confirms that the OMT announcement mitigates the herding contagion previously present in the region. Hence, it is more pertinent to interpret the contagion effects as uninformative coordination mechanisms or 'sunspots' than as wake-up calls originating from the fundamental-based learning effects in the markets. In general, our findings support De Grauwe's fragility hypothesis and the multiplist view of the crisis, which while not overlooking the importance of fundamentals gives a role to self-fulfilling panic that can push an otherwise solvent country towards default.

On the policy front, our paper informs a heated debate on the OMT program. Core members of the Eurozone have expressed disapproval for the policy by arguing that such unlimited bond-buying promises may discourage structural reforms and austerity plans or put excessive risks on Eurozone core members. In response to German eurosceptics' protests against the legality of the OMT program, the German Constitutional Court recently (as of February 2014) passed the case to the European Court of Justice; at the time of writing, the latter has still not produced a response. Our paper shows that the OMT announcement has been very effective in countering 'unnecessary' contagion in the Euro area. The evidence suggests that the new policy stance has helped not only the periphery (such as Italy and Spain) but also core members (such as Belgium and France) who are struggling to get their economies into pre-crisis form as their southern neighbours face the risk of deflation and stagnation. On this basis, we argue that the new ECB policy stance can be seen as beneficial for the interests of the Eurozone as a whole.

The full draft research paper can be downloaded below.