Looking back at markets in the decade before and after the introduction of the euro, the crisis was unexpected. Countries in the euro area could borrow at similar interest rates and default probabilities implied by those market rates were close to 0% for any of the countries in Southern Europe.
Why joining the euro area may foster debt crises
Such low interest rate differentials were sometimes perceived to be driven by the removal of exchange rate risk. Prior to the introduction of the euro, markets were charging higher interest rates to compensate for potential exchange rate movements.
However, joining the monetary union was also a constraint for countries, which ultimately should have increased default risk. Recent research has showed that joining the monetary union may make self-fulfilling debt crises more likely.
Recent research has showed that joining the monetary union may make self-fulfilling debt crises more likely.
Also, this means that countries have less tools to address domestic fiscal or macroeconomic shocks: for example, in the case of a bad shock such as a recession, countries were able to change the value of their currency, e.g., by devaluating it. Within the union, countries do not have this possibility, making a default a more likely possibility.
It is then a puzzle to have observed very low interest rates and very low default probabilities as this was the case in the 2000s.
Asset purchase bailouts by a government may explain low interest rates
To explain this puzzle, I argue that the expectation of bailouts is key – especially in the form of asset purchases – to explain low interest rates as experienced in the euro area.
More precisely, in my research, I build a model in which the expectation of interventions in form of asset purchases by a government explains why rates can be low on risky assets, despite their fundamental risk. The government stands for the core countries of the euro area and its institutions and risky assets for the debts of southern countries of Europe.
This model starts with the premise that a decline in the value of risky assets may push a government to rescue its banking sector. This is something commonly understood: banks are key to channel funds in the economy and a banking crisis may have huge consequences on economic activity. But a rescue plan may be difficult to implement in practice. In particular, it may require a lot of real-time information on banks’ portfolios.
A solution is then to directly buy the distressed assets. This proves to be useful especially if exposures to these assets are correlated with banks’ liquidity needs as, in this case, an asset purchase directly channels funds to the banks that need them the most.
This comes, however, with a cost: ex ante, if markets expect such interventions in the form of asset purchases, they will trade the potentially distressed assets with a premium, reflecting the implicit guarantee provided by the government.
My model also predicts that, ex ante, the banks take large positions in risky assets, consistently with what was observed in the financial sectors of the euro area’s core countries. Finally, ex post, asset purchases were part of the support provided to countries in the South of Europe, such as the Securities Markets Program (the first quantitative easing program) by the European Central Bank (ECB).
Key lessons from the euro area debt crisis
Be careful about the use of market values in regulations
First, a direct lesson of my research is simply a word of caution about the use of market values in regulations, as these market values may simply reflect bailout expectations. In contrast, regulators should pay more attention to overall exposures of their financial sectors to specific assets.
ECB tools and the risk of crises
Second, what is the relevant level of spreads across countries is still an open question in the euro area. A recent example is the introduction of the Transmission Protection Instrument by the ECB in July 2022. Such an instrument allows the ECB to purchase securities issued by public sectors of the euro area with the objective to limit sovereign spreads across euro area members and avoid a so-called fragmentation of the monetary union.
The rationale for using such an instrument is that spreads may diverge not only because of fundamentals but also because of self-fulfilling crises – in which higher spreads make debt refinancing more difficult for a country, ultimately leading to an unsustainable fiscal path that justifies initially higher spreads. And it is well understood that interventions related to this instrument should not be related to fundamentals.
Economic spreads may diverge not only because of fundamentals but also because of self-fulfilling crises.
But, in practice, to what extent is it possible to discern whether a surge in spreads is due to self-fulfilling market sentiments, a to deterioration in fundamentals or, even, both? And, ex post, if the financial sector has accumulated large exposures to a potentially defaulting country, what would be the temptation to purchase its debt, pretending that the country is simply facing a self-fulfilling debt crisis? These questions illustrate that moral hazard concerns due to asset purchases are not questions from the past, at least, in the euro area.
