Is There a Resolution to the Euro Area Debt Crisis?

By Holland, Dawn; Kirby, Simon | National Institute Economic Review, October 2011 | Go to article overview

Is There a Resolution to the Euro Area Debt Crisis?


Holland, Dawn, Kirby, Simon, National Institute Economic Review


Introduction

The financial crisis in the Euro Area continues to deepen. On 26 October 2011, European leaders put forward an outline of the next set of steps to be taken to tackle the crisis, but substantial uncertainty remains. A key plank of any resolution of the crisis is a credible plan to restore confidence in the debt of Euro Area governments. There is no evidence of this at the time of writing. (1)

The National Institute's baseline forecast presented elsewhere in this Review was based on the assumption of 'policy success'--that is that the proposals put forward would be sufficient to allow risk premia to begin to recede by the second quarter of 2012. An initial assessment of the proposals suggests that the likelihood of this best-case outcome is becoming more remote. In this note we present some potential alternative scenarios for the evolution of the Euro Area sovereign debt crisis. We look at possible responses by financial markets as well as alternative policy choices. These alternatives should be viewed as distinct forecast scenarios, with the probability distributions around each alternative contingent on the exogenous assumptions (including the evolution of the sovereign debt crisis) underlying the forecast.

The next section presents an overview of the events leading up to the crisis, including the policy responses to date: We then present three possible scenarios for the Euro Area. The first is an extension of the step-by-step approach that we have seen over the past 18 months, which can best be described as 'muddling through', where risk premia remain at current peaks for up to a year. The second scenario is one of sovereign default contagion. The final scenario considers Greece's exit from the Euro Area.

The Euro Area sovereign debt crisis

Financial integration in the Euro Area led to the situation where different member states' sovereign debt was largely treated as substitutes, bearing the same level of risk. Prior to the establishment of the euro this was not the case. The standard deviation of 10-year government bond spreads over those in Germany across the eleven original Euro Area members (2) dropped from an average of 1.08 in the five years leading up to the establishment of EMU in 1999 to just 0.062 on average in 2002. Greece maintained a margin over EMU country bond yields until it joined the single currency area in 2001, but this quickly dissipated once it became clear that the country had gained entry to the Euro Area. This convergence occurred despite the clear statement in the Treaty of Maastricht that member states retained full responsibility for their own debts, the 'no bail-out' clause.

Over the course of 2010 and 2011, both sovereign bond yields and money market conditions in the Euro Area increasingly diverged. With the onset of the financial crisis it became clear that the banking sectors in some countries were more fragile than others; investors began to differentiate Euro Area sovereign debt, as they realised that such debt was not necessarily risk-free, particularly given the contingent liability relating to the banking sector imposed on governments by the financial crisis. Figure 1 shows the standard deviation of bond spreads in the Euro Area (excluding members that joined after 2001) since 2007. Following a steady widening of the dispersion of bond spreads in the final months of 2008, variation in the Euro Area narrowed over much of 2009 as financial markets stabilised. The standard deviation of spreads began to rise again towards the end of the year, notably in response to developments in Greece, as new estimates revealed that the size of the government deficit in 2008 had been grossly underestimated. As a result credit rating agencies downgraded Greek sovereign debt in December 2009. This followed on from the downgrade of Irish sovereign debt in March 2009, when the magnitude of contingent liabilities incurred as a result of the government guarantee of all bank deposits became clear. …

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