Are markets now overestimating risks in Europe?

Paul De Grauwe and Yuemei Ji have written a paper on the same. They summarise it here.

They say first markets underestimated the risks between 2001-08  and are now overdoing things.

In a new paper (De Grauwe and Ji 2012) we argue that financial markets have not suddenly found the truth. Since the start of the sovereign debt crisis they have been making errors in the other direction. In other words, they are now overestimating risks. Using a panel data model, we find evidence that a large part of the surge in the spreads of the periphery countries between 2010 and 2011 was disconnected from underlying increases in the debt-to-GDP ratios and current-account positions, and was the result of negative market sentiments, even panic, that became very strong starting at the end of 2010.

Figure 1 illustrates this result. It presents pooled time-series and cross-section observations of the relation between the spreads of ten-year government bond rates of Eurozone governments compared with the German bond rate between 2000 and 2011 (quarterly observations). The red line represents the regression line indicating that increasing spreads are associated with increasing debt-to-GDP ratios. This line could be called the ‘fundamental relation’ between spreads and debt ratios. The most striking feature of Figure 1 is that at some point in time the spreads of some countries deviate spectacularly from the fundamental relation. We have circled these points of departure (defined as more than three standard deviations away from the fundamental line). They relate to Greece, Ireland, and Portugal – and they emerge in 2010.

This under and overestimation leads to policy mistakes on both sides:

The systematic mispricing of sovereign debt observed in the Eurozone also has the effect of giving the wrong incentives to policymakers. During the boom years, when financial markets were blind to the sovereign risks, no incentives were given to policymakers to reduce their debts, as the latter were priced so favourably. Since the start of the financial crisis financial markets driven by panic overpriced risks and gave incentives to policymakers to introduce excessive austerity programmes. This panic has now been transmitted to the European Commission that is urging Eurozone countries to intensify budgetary austerity programmes while the Eurozone is moving into a recession – an extraordinary repeat of the 1930s.

To summarise:

  • In a world where spreads are tightly linked to the underlying fundamentals such as the debt-to-GDP ratio, the only option the policymakers have in reducing the spreads is to improve the fundamentals. This implies measures aimed at reducing the debt burden.
  • If, by contrast, there is a disconnect between spreads and fundamentals, a policy geared exclusively towards affecting the fundamentals (ie reducing the debt burden) will not be sufficient.

In that case policymakers should also try to stop countries from being driven into a bad equilibrium.

The solution is ECB liquidity and support by buying bonds something De Grauwe has been stressing all along.

This can be achieved by more active liquidity policies by the ECB that aim to prevent a liquidity crisis in government bond markets from leading to a self-fulfilling solvency crisis (see Wyplosz 2011 and De Grauwe 2011b on this site).

It should be stressed that:

  • Policy aimed at improving the fundamentals through budgetary austerity and the policy of liquidity provision by the central bank are not substitutes, but complements.
  • When a member country of a monetary union is hit by a liquidity crisis that leads to a disconnect between the spreads and the fundamentals, both policies will in general be needed.

All too often these two types of policies have been seen as ‘either/or’. In fact, in a monetary union conditions can arise in which both types of policies are required.

 Amazing change of sentiments in Europe

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