Fiscal Austerity, Borrowing Costs and the Eurozone Economies

Πηγή: SEJ
By IYANATUL ISLAM and MARTINA HENGGE
July 12 2012

The current approach to fiscal austerity measures as a means of resolving the Eurozone sovereign debt crisis is widely regarded as ineffective. Economies, most notably in Southern Europe, undergoing the pain of fiscal austerity measures have not seen a significant reduction in long run borrowing costs (as measured by 10-year interest rates). Attaining the latter is important both for debt sustainability as well as kick-starting growth in the debt-distressed Eurozone economies. What went wrong?

There are many criticisms that one can level against the uncritical embrace of fiscal austerity measures as a response to sovereign debt crises. Here, we explore the widely held – but largely unsubstantiated – view among policy-makers that international capital markets populated by ‘bond vigilantes’ care largely or exclusively about national debts and deficits. Hence, cutting deficits in a resolute fashion in order to reduce public indebtedness is expected to be rewarded by lower borrowing costs because it will restore ‘market confidence’. Such reduced costs in turn are expected to spur investment, growth and creation of jobs. As a former President of the ECB put it, ‘At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable’.[1] The British Prime Minister delineates the perceived linkages between interest rates, debts and deficits quite clearly: ‘If markets don’t believe you are serious about dealing with your debts, your interest rates rocket and your economy shrinks’.[2]

These pronouncements by influential policy-makers (both past and present) overlook the fact that multiple studies show that formal assessments of sovereign credit worthiness by credit rating agencies routinely include growth indicators in addition to measures of debts and deficits.[3] What is perhaps less well known is that growth has a more significant impact on sovereign default risks than debts and deficits.[4] The implication is that that cutting deficits to reduce public debt might be self-defeating given that such actions typically reduce growth raising doubts among ‘bond vigilantes’ about the sustainability of fiscal austerity measures.

We show in Figure 1, based on a sample of observations for Eurozone economies, that there is an expected negative correlation between annual growth rates and long run borrowing costs.Figure 2 exhibits the expected positive correlation between long run interest rates and annual changes in gross debt-to-GDP ratios. On the other hand, our attempt to plot an association between annual declines in structural deficits and long run interest rates yields the seemingly counter-intuitive pattern that fiscal tightening is not associated with lower interest rates – seeFigure 3.

We combine the information in the aforementioned figures into a simple regression estimate. We find that a one percentage point increase in the GDP growth rate is associated with a statistically significant decrease in borrowing costs of 0.75 percentage points. A one percentage point increase in the annual debt-to-GDP ratio, on the other hand, has a comparatively smaller impact on long run interest rates (of the order of 0.26 percentage points). In addition, we could not ascertain any statistically significant impact of changes in fiscal deficits on long run interest rates. It thus follows that the current pursuit of fiscal austerity measures in the case of the Eurozone economies is unlikely to accomplish its key objective of reducing borrowing costs on a sustainable basis. It also supports the contention of those who advocate the need to focus on growth in dealing with the debt-distressed economies of the Eurozone.

Figure 1

Eurozone – GDP growth rates are negatively correlated with 10 year interest rates, 2010-2011



Sources: OECD Key Short-Term Economic Indicators (June 2012) and IMF World Economic Outlook (April 2012).



Figure 2

Eurozone – higher increases in the debt-to-GDP ratio are associated with higher interest rates, 2010-2011

Sources: OECD Key Short-Term Economic Indicators (June 2012) and IMF World Economic Outlook (April 2012).

Figure 3

Eurozone – fiscal tightening is not associated with lower long run interest rates, 2010-2011

Sources: OECD Key Short-Term Economic Indicators (June 2012) and IMF World Economic Outlook (April 2012).



[1] See European Central Bank, Interview with Jean-Claude Tritchet, President of the ECB, and Liberation, July 8, 2010


[2] David Cameron, ‘A Speech on the Economy,’ Thursday, May 17, 2012 available at http://www.number10.gov.uk/news/pm-economy-speech/


[3] See, for example, Alfonso, A., Gomes, P. and Rother, P. (2011) ‘Short and Long-run Determinants of Sovereign Debt Credit Ratings’, International Journal of Finance and Economics, 16(1), 1-15. See also European Parliament (2011) Rating agencies – Role and influence of their sovereign credit risk assessment in the euro area, Monetary Dialogue December 2011.


[4] Cottarelli, C. and Jaramillo, L. (2012) ‘Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies’ IMF Working Paper 12/137.

About Iyanatul Islam and Martina Hengge

Iyanatul (‘Yan’) Islam, a Cambridge- educated economist, is currently Chief, Country Employment Policy Unit, Employment Policy Department, ILO Geneva. Martina Hengge, a graduate of the University of St Andrews, is currently working on macroeconomic and labour market policies for the Country Employment Policy Unit at the International Labour Office (Geneva).

The Euro on the Brink: 'Multiple' Crisis and Complex Solutions

Πηγή: chathamhouse
By Paola Subacchi and Stephen Pickford
Macro Economy Proceedings, Nomura Foundation, Issue no 7, January 2012


Euro Zone Crisis

Are euro zone bonds the new subprime?

Πηγή: Time
By MICHAEL SCHUMAN

Wednesday, September 14, 2011

So we all by now know the story of how the global economy fell into the 2008 financial crisis. Banks gorged themselves on high-yielding U.S. subprime mortgage securities, which were awarded top credit ratings (perhaps fraudulently). When those investments proved as financially sound as the over-leveraged homeowners behind them, the foundation of the financial system crumbled like cheap Chinese wallboard. From Wall Street, the shockwaves ricocheted around the world. And we ended up in the Great Recession.

Now we have to ask if something similar is going on in Europe. But this time around, a very different sort of subprime security is at the heart of the problem – the sovereign bonds of euro zone countries. Here's what I mean:

Just as deteriorating subprime securities ate away at the balance sheets of major American and European banks, the same could happen with euro zone bonds issued by the weak PIIGS. Those bonds are already losing value as yields escalate. Even if Greece manages to avoid a default, the second bailout package has losses built in for private holders of Greek bonds. In a scary scenario, the euro crisis deepens, the bonds of Greece, Ireland, Italy and the other PIIGS lose more and more value, weakening the European banking sector. Banks in Europe holds billions of dollars of PIIGS bonds, so the impact could be severe. Then the fallout gets spread around the world through globalized banking and financial markets. And it's 2008 all over again. Here's how economist Ken Courtis put it in a recent, anxiety-ridden email:

Several banks are going to look like BSC or LEH.. and not just PIIGS banks... think BNP, think Barclays,... Some of these banks have exposure to PIIGS sovereign debt several times their equity. Then there are other PIIGS exposures, such as investments in PIIGS banks, loans to PIIGS companies, local real estate market exposure....which only increases further the vulnerabilities…On its present course, Europe is on a crab walk to disaster...and should that happen, there would be very few places to hide, for anyone.

Holy junk bonds, Batman! How likely is such a scenario? It is always extremely difficult predicting financial crises, and I don't intend to try it out myself. However, the euro zone sovereign debt crisis does appear to be morphing into a renewed banking crisis. The shares of major European banks have taken a vicious pounding in recent days amid fears that Greece will default. On Wednesday, Moody's downgraded the credit ratings of two of France's most important banks -- Societe Generale mainly because of the impact the debt crisis could have on its financing, and Credit Agricole in part due to its exposure to Greece. Christian Noyer, governor of France's central bank, brushed off the downgrades as “very small,” which they are. But Noyer is missing the point. Concern about the health of Europe's banks has always lurked in the background of the debt crisis, but European leaders have generally ignored it (with exceptions, such as a bank restructuring effort in Spain). Europe-wide “stress tests” of the region's banks, aimed at bolstering confidence in the sector, were generally criticized as too soft. So like two enfeebled octogenarians trying to hold each other upright, a potentially shaky banking sector has been supporting debt-laden, wobbly governments, which then are expected to back up the banks.

However, at the same time, we shouldn't get too far ahead of ourselves. In its announcement of its downgrades, Moody's made clear the France's banks had the capital to absorb losses on Greece, as well as Portugal and Ireland. That means the euro debt crisis is likely going to have to get significantly worse to really undercut banks in Europe. My guess is that jitters about the banks in Europe will ease if the uncertainty over the continued bailout of Greece is resolved. In other words, euro zone bonds aren't quite subprime – at least not yet.

But the risk is out there. If Europe's leaders really want to stem the debt crisis, they should find ways of shoring up the banks, or getting the banks to raise their own capital, before we do face a renewed subprime crisis. My fear is that the lack of foresight among Europe's politicians that has gotten the euro zone into this mess will persist, placing the European financial system in danger. And then, as Courtis says, there would be nowhere to hide.