1. Macroeconomics Prof. Juan Gabriel Rodríguez The Sovereign Debt Crisis

2. A paradox In 2011 as a percent of GDP the UK government debt stood 17% higher than the Spanish government debt (89% Vs 72%). The yield on Spanish government bonds has increased strongly relative to the UK (in 2011, a difference of 200 basis points!) - Why? The banking sector in the UK is not better than the banking sector in Spain so… Spain belongs to a monetary union!!!

3. Sovereign Debt in a Monetary Union The “UK Scenario” Assume investors were to fear that the UK government might be defaulting on its debt… – They would sell their UK bonds, driving up i. – They would sell their “new” pounds in the foreign exchange market. – The price of pounds would drop, but pounds would be bottled in the UK money market to be invested in UK assets (the UK money market would remain unchanged). – If the government cannot find the funds to roll over its debt at reasonable interest rates, it would force the Bank of England to buy government securities. Investor cannot precipitate a liquidity crisis in the UK!

4. Sovereign Debt in a Monetary Union The “Spanish Scenario” Assume investors were to fear that the Spanish government might be defaulting on its debt… – They would sell their Spanish bonds, driving up i. – They would invest their Euros, say in German bonds so the Euros leave the Spanish banking system. – Because no foreign exchange market, nor a flexible exchange rate can stop this, liquidity (money supply) in Spain shrinks. – The Spanish government cannot obtain funds at reasonable interest rates. Moreover, the Bank of Spain cannot buy government bonds. The ECB could do it, but the Spanish government does not control it. The liquidity crisis, if strong enough, can force the Spanish government into default! Financial markets acquire power to…

5. Sovereign Debt in a Monetary Union The “Spanish Scenario” Furthermore, because the national currency does not depreciates (see the case of UK) the Spanish economy is not given a boost and prices do not change… Since 2010: – Inflation: 2.9% Vs 1.6% – Growth: 2% Vs 0.2% – The pound has depreciated by 25% against Euro. Recall: Primary budget surplus must be at least as high as the difference between the interest rate and growth rate times the debt ratio for solvency (stabilization of the debt to GDP ratio)…

6. Sovereign Debt in a Monetary Union The “UK Scenario”: -1.21 The “Spanish Scenario”: 2.30 Spain is forced to apply much more austerity than the UK to satisfy the solvency condition, despite the fact that it has a substantially lower debt level!!! Dynamics in a monetary union: when investors fear some payment difficulty (triggered by a recession that leads to an increase in the government budget deficit) liquidity is withdrawn from the national market. Once a member country gets entangled in a liquidity crisis, interest rates are pushed up, and in this manner, the liquidity crisis turns into a solvency crisis. A self-fulfilling prophecy: the country has become insolvent because investors fear insolvency

7. Sovereign Debt in a Monetary Union Further considerations - Financial markets acquire great power in a monetary union, will this power be a discipline force on bad governments? The problem is that financial markets are driven by extreme sentiments: during periods of euphoria investors cheered by rating agencies, fail to see the risks and take too much; after, fear dominates and investors prodded by rating agencies detect risks everywhere. - When a bad equilibrium is forced on some member countries, financial markets and banking sectors in others countries are also affected (for many Eurozone member countries more than half of government bonds are held outside the country of issue). - Because the interest rate on government bonds increases, the domestic banks which are usually the main investors in the domestic sovereign bond market, will suffer losses on their balance sheets. Moreover, because liquidity has dried up, domestic banks have difficulties to rollover their deposits. Thus the sovereign crisis spills over into a domestic bank crisis and credit to the economy disappears. - A recession leads to higher government budget deficits which trigger a liquidity and solvency crisis. The latter forces to institute austerity programs in the midst of a recession.

8. Sovereign Debt in a Monetary Union Governance - European Financial Stability Mechanism that will be the European Stability Mechanism (ESM) from 2013 on. This organism will obtain funding from the participating countries and will provide loans to countries in difficulties. - Interest rate too high - Austerity package spelled out over a sufficiently long period of time, so that economic growth gets a chance. - Collective actions clauses: private bondholders know that their bonds will automatically lose value when a country turns to the ESM…but this will make it more likely that the country need support from the ESM! - Joint issue of Eurobonds: internalizing the externalities. Problems: moral hazard (issue too much debt), less favourable credit ratings. - Coordination of Economic Policies: control bank credit (reserve requirements, capital ratios)