The eurozone predicament: three crises – many feedback loops – one figure

The evolving eurocrisis is a complex  beast. It consists of three interacting crises: a banking crisis, a sovereign debt crisis, and an economic growth crisis. To make things worse,  these crises are connected by multiple feedback loops. The figure below helps me when discussing the eurocrisis. It summarizes the three crises and their interactions.

eurocrisis - feedback loops

The banking crisis that followed after the collaps of Lehman increased sovereign debt because sovereigns were forced to bail out banks (1). Next, with some delay, the banking crisis hit growth because banks cut back on lending in an effort to deleverage (2). The drop in growth decreased tax income and increased unemployment benefits, further raising government debt (3). This triggered a loss of confidence in the ability of Greece, Portugal, Ireland to repay their debt, while raising first doubts on Italy and Spain (4 and 9).

At the same time, countries’ reduced creditworthiness hit the banking sector because the latter depended on implicit subsidies (5) and held large fractions of sovereign debt on their balance sheets (6). The deteriorating health of banks negatively impacted economic growth (2). As a consequence, loans turned bad at an increasing rate and banks were hit yet again, e.g. in Spain (7), while also hitting governments tax income (3). Because governments are expected to bear the burden of recapitalizing banks, their creditworthiness decreased further (1).

To restore market confidence, governments began to cut spending and increase taxes. This had a negative impact on economic growth (8), further deteriorating the quality of loans on banks’ balance sheets (7). At the same time the growth crisis threw doubt on the ability of sovereigns such as Italy and Spain to restore health to their economy without defaulting on their debt or implementing further austerity measures, as well as the willingness and ability of core eurozone countries to do what it takes to save the euro, further deepening the sovereign debt crisis (9).


Why do governments pay back their debt?

In public discussion debt is simply debt. But different flavors of debt exist. In fact, debt issued by sovereigns is very different from debt that is issued by private firms (and debt issued by sovereigns in a monetary union is still different, but I will not discuss that here). The reason is that a country’s creditors have very limited means to enforce their claims. Countries can not credibly offer their production assets as collateral for a loan, while the doctrine of sovereign immunity in international law protects sovereign assets even when they are located in foreign jurisdictions (though there are exceptions and immunity can be waived)

This begs the question why sovereigns pay back their debt at all. Rational governments will pay back their debt as long as the benefits of doing so outweigh the costs of defaulting on their debt payments. In practise, countries and their creditors will renegotiate the debt contracts. The costs of default will then determine the outcome of this process. Four types of costs exist. See Panizza, Sturzenegger and Zettelmeyer for an overview.

Exclusion from capital markets

The first potential source of costs arises because sovereigns that do not pay back their debt may be shut out of international money markets. However, for several reasons this cost may not be so high in practice. Logically, default reduces the sovereigns’ debt burden and increases its creditworthiness. Sufficiently reduced debt levels would then make lending profitable again. Consequently, the threat to exclude sovereigns that default on their debt from future lending is not credible. In addition, sovereigns might have recourse to other sources of emergency financing, further undermining the disciplining force of capital market exclusion. This limits the ability of capital markets to discipline governments into paying their debt.

Empirical evidence indeed suggests that renewed access to international capital markets is currently faster than in previous decades. Borensztein and Panizza find that the economic costs of exclusion are short-lived. The spread increases with about 400 basispoints the first year after a default, which reduces to 250 basispoints the second year and becomes small after that.

Direct punishment

A second source of costs may be direct punishments. This means that creditors try to impose sanctions on a country, for example through seizure of tradeable assets or payments that occur outside a country’s borders. This should of course both credible and be legally possible, which restricts the type of sanctions creditors will impose in practise. The threat of imposing sanctions will be credible if the creditor benefits from them. Some recent litigation cases (see e.g. here) may have strengthened the legal possibilities to impose such sanctions.

Empirical evidence suggests that foreign direct investment and trade credit indeed drop after a default. But where some studies find this effect to last for more than a decade, see Rose, others find that the negative effect dissapears after one or two years, see Borensztein and Panizza. In addition, it is unclear that this drop is due to sanctions, see Martinez and Sandleris.

Costs from impaired financial sector

A third potential cost arises from the substantial fraction of sovereign debt is generally held by national banks. Thus, when a country defaults on its debt, banks take a loss. This may induce a credit crunch where banks try to restore their equity levels by reducing credit to the private sector. The economic costs of such a credit crunch are sizeable.

Borensztein and Panizza find that sovereign default does not lead to a credit crunch by impairing the financial sector. For countries in a monetary union, however, this might be different because they lack the ability to recapitalize their banks via their own central bank.

Political costs

Finally, governments may pay back their debt because they face political costs if they fail to do so. Voters may blame ministers and the top executive politicians if a country defaults on its debt and vote them out of office. Voters’ adverse attitude towards default will most likely be stronger if they hold some level of the debt themselves, either directly or through institutionalized savings such as pension schemes.

The political consequences of a debt crisis for incumbent governments and finance ministers seem to be significant. Borensztein and Panizza find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support, and that in 50 percent of the cases there was a change in the chief of the executive either in the year of the default episode or in the following year.

Why is this important?

All in all, political costs and the consequences of a default for the financial sector in a country may be important elements in providing incentives for sovereigns to pay back their debt. If debt held nationally, either by voters, banks or pension funds, plays a role in strengthening these incentives, then we should realize that increased diversification of the holding of sovereign debt within the eurozone, for example through the introduction of eurobonds, may diminish these incentives.

The value of sovereign debt

While in the blogosphere economists argue on the level of fiscal multipliers, whether or not debt is a burden on future generations, and why governments should cut or increase spending (see also here), the discussion ignores a fundamental and interesting question. Why does government debt exist at all? Would sovereign debt arise in a world ruled by benign and rational politicians?

In addressing this question, it is useful to start from a perfect world. In this world, consumers anticipate that the government will have to raise taxes in the future to pay off its debts. Therefore once a government issues debt, consumers will start saving to pay for that future tax increase. Consequently, an increase in government debt has no impact on consumption (the infamous Ricardian equivalence). By issuing debt instead of raising taxes the government merely reallocates consumption. Now if markets work perfectly, reallocating consumption will distort efficient prices and can only reduce welfare. Thus, in this ‘perfect’ world, sovereign debt is useless or even harmful.

Of course, the world is not perfect and government debt might have value because of the presence of imperfections, such as incomplete contracts or asymmetric information. I discuss five reasons related to these imperfections below.

But first a caveat. The complexity of a topic can be judged by the amount of issues one has to ignore before getting straight answers. By that standard, sovereign debt is a complex topic. What happens if the government is subject moral hazard, short-termism and other imperfections? Why do creditors believe that governments will repay their debt at all?  What should the appropriate intergenerational discount rate be? All these are worthy questions that deserve deep discussion – but not in this post.

Reason one – smoothing ups and downs in economic circumstances (insurance)

The most commonly mentioned reason for sovereign debt is that countries use debt to absorb shocks. When a banking crisis hits, governments respond by rescuing the financial system. When the economy tanks, government expenditure increases while tax receipt decrease. Accommodating these shocks entirely through changing tax rates or shrinking government expenses may be costly. Accumulating debt may be an alternative way to accommodate such shocks. Note that such an insurance mechanism may be more valuable when other mechanisms, such as a flexible exchange rate, are absent.

Reason two – meeting a demand for liquid assets

Another reason may be the government debt responds to a demand for liquid assets. Very safe assets allow firms or banks to temporarily park their cash and can function as collateral. It is akin to a form of money. Thus, there might be a natural demand for such assets and if the level of sovereign debt is very low, then the price investors are will to pay for these kind of financial assets is very high. This makes issuing debt an attractive way for governments to finance their expenditures.

Reason three – financing profitable investments for financially constrained generations

A current generation may face a situation where a lot of socially desirable investment opportunities are present, but there is simply too little cash to pay for these. Debt is then a way to shift income from future generations to current generations. Of course, a benevolent government only does so if they think future generations will face circumstances with less valuable investments.

Reason four – distributing the costs of investments between current and future beneficiaries of investments

Future generations may also benefit from current investments in for example infrastructure, human capital, or the quality of institutions. Consequently, it is efficient that part of the burden of making these investments falls on future generations.

Reason five – as a device for politicians to commit to good conduct by exposing themselves to market discipline

Another reason may be that sovereign debt introduces market discipline. The price of sovereign debt may create a market signal. A high price then signals that the government is not conducting good economic policy. In addition, because voters often hold a considerable fraction of their sovereign’s debt, politicians commit themselves to prudent government by issuing debt.

What do we learn from this? Well, although debt ceilings undoubtedly have benefits, if debt and changes in debt levels have an economic function then setting such ceilings too low may also have costs. And these costs may be particularly high when it truncates the already limited ability of governments in a monetary union to insure their population against economic shocks.

Fiscal multipliers and their (dis)content

Fiscal multipliers measure the effect of changes in government fiscal policy on GDP.  They aim to capture the behavior of a multitude of individual housholds and firms in a single number. As such, it should come as no surprise that the ultimate fiscal multiplier does not exist. Consumers and firms react differently to different policy measures. Consequently, different types of policy measures have different multipliers. Consumers and firms behave differently under different economic circumstances. Multipliers may therefore depend on these circumstances.

More specifically, one may conjecture that in an open economy part of the fiscal stimulus may just increase imports. Or that government stimulus will have a larger effect if private agents face (financial) constraints. And that multiplier effects may be larger when the central bank accommodates fiscal policy or is bound by a zero interest rate.

And this is indeed what empirical research seems to show. A working paper by Sebastian Gechert and Henner Will looks at 89 studies on fiscal multipliers. The graph below shows the frequency distribution of multipliers found in studies using different types of models ( in technical terms – New Classical RBC (or D(S)GE) models, New Keynesian DSGE models, structural macro-econometric models, VAR models, and all kinds of single equation estimation techniques. Check the paper if you want to know more). The graph shows substantial variation between these different methods.

This has two consequences. First, it matters  which model economists use to assess the potential benefits of additional government spending. If a model doesn’t include the possibility of monetary policy being at the zero lower bound, or does not incorporate agents that are – for example – credit constrained, it will underestimate the effect of additional government spending. Second, the choice for a particular model that economists make may itself become the subject of a political discussion. If commentators don’t like the outcome of a particular analysis, they may well argue that this is due to the subjective choice for a particular model of the economist in question.

Why eurozone countries need independent fiscal watchdogs

What happens if countries in a monetary union set ambitious goals for budget deficits and growth?  They start making overly optimistic forecasts. This paper by Jeffrey Frankel and Jess Schreger from Harvard has some informative graphs. The first graph below shows how the two year ahead forecasting error differs per country. Greece, Ireland, Portugal, and Spain come out on top. The second graph shows how the average forecasting error varies over time. The forecasting error dropped just before the introduction of the euro and rose soon after.

The authors then go on to show that “euro area governments making forecasts while in violation of the EDP with an independent fiscal institution that makes independent budget forecasts have a mean bias that is smaller by 2.9% of GDP at the one-year horizon and 2.6% of GDP at the two year horizon, compared to a euro area country violating the EDP without such an independent fiscal institution.” I rest my case.

Finance – can there be too much of a good thing?

An important policy question is: how big should the financial sector in a country be. Can there be too much finance? A recent IMF working paper by Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza suggests there is a threshold above which financial development no longer has a positive effect on economic growth. They find that finance starts having a negative effect on output growth when credit to the private sector reaches 100% of GDP. Below is a graph of the effect of credit to the private sector on growth that shows this inverted U-shape relation between credit to the private sector and growth.

And here are the countries that are just below or above the optimal level

The economics of eurobonds

Proposals for eurobonds abound: Delpla and Von Weizsacker, Hellwig and Phillipon, Brunnermeier and others , German council, Boonstra. Most aim to shield countries from sovereign debt crises. Indeed, a common observation is that Europe as a whole has a lower debt to GDP ratio than the United States or Japan. At a more abstract level, eurobonds are one answer to the following question: how can eurozone countries create some form of mutual insurance while stopping short of full-fledged political integration of federative states like Germany or the US. But what do we know about the economics of eurobonds? Eurobond proposals need to deal with four issues: moral hazard, externalities, contagion and credibility.

Moral hazard

A central issue in designing optimal insurance schemes is how to address moral hazard. Eurobonds insure against events that raise interest rates. In particular, they insure against both liquidity risk and solvency risk. Most economists believe that solvency risk is at least to some extent driven by economic policy. Thus, insured countries can make a costly effort to reduce the risks they are insured against by reducing debt (e.g. by cutting spending), increasing growth (e.g. by labor market reforms or reducing entry barriers in product markets), or increasing resilience to shocks (e.g. by strict banking regulation or limiting private sector debt). When such effort is unobservable or noncontractible, this raises the issue of moral hazard.


In the presence of externalities, it may be difficult to agree upon the optimal amount of insurance. Suppose problems in one country have significant negative consequences for another country, but vice versa the impact is much less. In that situation, the two countries will want different levels of insurance. The optimal level of insurance will lie somewhere in between the two levels. To get the countries to agree might be difficult if transfers are not possible.


Suppose two countries have mutually insured themselves. This implies that shocks that raise one countries’ interest rate will now also raise the other countries’ interest rate as well. It is in principle possible that a shock that would pull only one country down now pulls both countries debt levels into unsustainable territory. The figure below illustrates this in a simple setting. Suppose countries without mutual insurance go bankrupt if the shock exceeds some level A. On the right hand side the region where both countries survive is smaller than on the left-hand side. These are benefits of insurance. The area where both countries fail together, however, is larger on the left-hand side. These are costs of mutual insurance.


Finally, insurance should be credible. When a country could withdraw from the insurance scheme if that were desirable for the country in question, this would undermine the effectiveness of the scheme. It may happen that while insurance is optimal for a country ex ante when it is not known who will be hit by the shock, ex post once shocks have occurred it may not be optimal for a country to pay up.