During the decade preceding the eruption of the financial crisis in August 2007, rating agencies and market participants, gripped by euphoria, systematically underestimated the risk inherent in a wide range of financial assets. Today the panic that has gripped them leads to an equally distorted view of the risks involved. Private debt is dumped in favour of government debt of just a few countries. How these countries are selected is unclear. This selection mechanism is the result of an emotional reaction that leads market participants to believe that “it is inconceivable that serious countries like the US, Germany or France would ever default on their debt” while other countries are deemed to be to be capable of doing such a bad thing. These emotional reactions create distortions that affect economic activity in profound ways

De Grauwe, Paul.

English

Archive of European Integration

Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior Fellow at CEPS. ECMI Commentaries provide short comments on ongoing developments affecting capital markets in Europe. ECMI researchers as well as external experts contribute to the series. The views expressed are attributable only to the author in a personal capacity and not to any institution with which he is associated.  Available for free downloading from theECMI website (http://www.eurocapitalmarkets.org and the CEPS website (http://www.ceps.eu) y © Paul De Grauwe 2009  Why should we believe the market this time? ECMI Commentary No. 22/20 February 2009 Paul De Grauwe preads of sovereign debt within the eurozone have increased dramatically over the past few months. Figure 1 shows the evidence. The governments of Greece and Ireland now (February 2009) pay an interest rate on their debt that exceeds the German government bond rate by more than 200 basis points, while the governments of Spain, Portugal and Italy have to pay more than 100 basis points extra.   Figure 1.  Interest differential with Germany (long-term government bond rates)00,511,522,53Nov. 07Dec. 07Jan. 08Feb. 08Mar. 08Apr. 08May 08June 08July 08Aug. 08Sep. 08Oct. 08Nov. 08Dec. 08Jan. 09percentage pointsGreeceIrelandItalyPortugalBelgiumSpainAustriaFinlandNetherlandsFrance Source: ECB, https://stats.ecb.int/stats/download/irs/irs/irs.pdf and FT for Jan 09.  Since all these bonds are expressed in the same currency, the euro, these spreads reflect a pure default risk (assuming that the German bonds are free of default risk). Thus the market now takes the view that the governments of these countries will default on their debt in the foreseeable future.  S  How reasonable is such a forecast? It will remain difficult to answer that question. The fact that none of the Western European countries have defaulted on their debt in the last 60 years does not preclude that they will do so in the next 50 years. It is difficult to understand, however, why the market (and the rating agencies) forecast a default of the Spanish government debt, while it does not make such a forecast for the UK, which has experienced a similar buildup of its debt as Spain and whose banking problem is more serious than Spain’s.  My hypothesis is that the widening bond spreads within the eurozone are the result of panic in the financial markets. The panic that followed the banking crises has led investors into a stampede away from private debt into assets that are deemed safe. These are mainly government bonds of a few countries that are perceived to provide safety. The US, Germany and possibly France are a few of these countries that for some strange reason have been singled out as supplying safety. Other countries do not profit from the same ‘panic flight to safety’. This is shown in Figure 2, which presents the levels of the government bond rates in the eurozone. We observe a significant decline of the German government bond rate by close to 100 bp. Surely it cannot be the case that holding German bonds in February 2009 is significantly less risky than a year earlier. But Germany was singled out by the market as the country that provided safety. France also benefitted from this, but less so. With the exception of Greece and Ireland, the other countries kept their bond rates more or less unchanged (compared to a year ago) suggesting that these countries were bypassed by panicky investors. Only Greece and Ireland saw their bond rates increase significantly over the last year, suggesting that the increased spreads of these countries are not only due to panic.  Figure 2.  Long term government bond rates in eurozone33,544,555,56Nov. 07Dec. 07Jan. 08Feb. 08Mar. 08Apr. 08May 08June 08July 08Aug. 08Sep. 08Oct. 08Nov. 08Dec. 08Jan. 09percentGreeceIrelandItalyPortugalBelgiumSpainAustriaFinlandNetherlandsFranceGermany Source: ECB, https://stats.ecb.int/stats/download/irs/irs/irs.pdf and FT for Jan 09.   Panic is never a good guide for risk analysis. It distorts prices and gives wrong incentives. During the decade preceding the eruption of the financial crisis in August 2007, rating agencies and market participants, gripped by euphoria, systematically underestimated the risk inherent in a wide range of financial assets. Today the panic that has gripped them leads to an equally distorted view of the risks involved. Private debt is dumped in favour of government debt of just a few countries. How these countries are selected is unclear. This selection mechanism is the result of an emotional reaction that leads market participants to believe that “it is inconceivable that serious countries like the US, Germany or France would ever default on their debt” while other countries are deemed to be to be capable of doing such a bad thing. These emotional reactions create distortions that affect economic activity in profound ways.  More specifically, the interest rate spreads faced by southern European countries and Ireland are giving the governments of these countries incentives to reduce their efforts to stabilise their economies. Extra spending which leads to higher deficits is punished by a higher interest cost, discouraging these countries to stimulate their economies. No such penalties are imposed on Germany and France.   In addition, these spreads create a perception of future default crises and impending fiscal doom, which impacts on the effectiveness of budgetary policies. We know that fears of future default crises reinforce the ‘non-Keynesian’ effects of fiscal policies, i.e. when agents fear such future crises, they are more likely to react to budgetary stimulus by increasing their savings (see the well-known paper of Giavazzi & Pagano, 1996). As a result, budgetary stimulus packages lose their effectiveness.   The penalties imposed by increasing spreads on southern European counties and Ireland also create negative externalities. For example, the rescue of banks in these countries is more expensive than in the rest of the eurozone, making it more difficult to resolve the banking crisis in these countries. This is likely to lead to further weakening of economic activity in these countries with possible feedback again on the banking system, on the government budget deficits and on the ratings applied by the rating agencies. How should one deal with these distortions and externalities? It will remain difficult to prevent cycles of euphoria and panic from affecting perceptions of risk in the markets. Authorities can, however, attempt to offset the distorting effects these cycles produce. The European Central Bank, in particular, has the tools to do just that. Here is my proposal. As the ECB will be forced very soon to engage in quantitative easing, it will be buying long-term assets, in particular government bonds. It should at that moment, privilege the buying of Irish, Greek, Spanish and Italian government bonds. In doing so, it would increase the price of these bonds and reduce their yields. Thus such a quantitative easing would tend to reduce the spreads in government bonds in the eurozone, and would eliminate the distortions and the externalities that these spreads create. It would also make it possible to stimulate the economies of all eurozone member countries, benefitting the whole area.   Clearly this proposal will meet with much resistance. We now increasingly hear the story that the market is punishing profligate governments, and rightly so. But why should we trust the market judgments any better now than five years ago when the same market (orchestrated by rating agencies) completely misjudged the risks that existed in the financial markets? When the market was so wrong in the past, why should we believe it now and accept its verdict? We should not. The spreads that have been created  within the eurozone are largely the result of panic. We can and should correct for the distortions and externalities this is creating.  This being said, it remains the case that Spain, Ireland, Italy and Greece face important adjustment problems. These countries have experienced relatively high wage and price inflation in the last ten years leading to a loss of competitiveness. This is shown in Figure 3. Part of the higher domestic price and wage inflation may be due to the Balassa-Samuelson effect, but this is unlikely to be the case in all these countries. Spain and Italy, for example, have experienced sluggish productivity growth. It follows that these countries will have to go through a period of adjustment aimed at redressing their competitive position, very much like Germany did during the first five years of the eurozone. This will be a painful process. The overriding problem these countries face today, however, is the same as everywhere else, i.e. how to counter the deflationary effects of the financial crisis. There is no reason why these countries should be singled out to be punished. This punishment will make it more difficult to adjust to the deflationary dynamics. It will also not help them in regaining their competitive positions.   Figure 3. Relative unit labour costs in the eurozone 80901001101201301998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Real effective exchange rate IrelandSpainItalyPortugalNetherlandsGreeceFranceBelgiumFinlandAustriaGermany Source: European Commission, European Economy.  Reference  Giavazzi, Francesco and Marco Pagano (1996), “Non-Keynesian effects of fiscal policy changes: International evidence and the Swedish experience”, Swedish Economic Policy Review, May. 

Non-Keynesian effects of fiscal policy changes:

Why should we believe the market this time? ECMI Commentary No. 22, 23 February 2009

Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior 
Fellow at CEPS. 
ECMI Commentaries provide short comments on ongoing developments affecting capital 
markets in Europe. ECMI researchers as well as external experts contribute to the series. The 
views expressed are attributable only to the author in a personal capacity and not to any 
institution with which he is associated. 
 
Available for free downloading from theECMI website (http://www.eurocapitalmarkets.org and the 
CEPS website (http://www.ceps.eu) ? © Paul De Grauwe 2009 
 
Why should we believe the market this time? 
ECMI Commentary No. 22/20 February 2009 
Paul De Grauwe 
preads of sovereign debt within the eurozone have increased dramatically over the 
past few months. Figure 1 shows the evidence. The governments of Greece and 
Ireland now (February 2009) pay an interest rate on their debt that exceeds the 
German government bond rate by more than 200 basis points, while the governments of 
Spain, Portugal and Italy have to pay more than 100 basis points extra.  
 
Figure 1.  
Interest differential with Germany 
(long-term government bond rates)
0
0,5
1
1,5
2
2,5
3
N
ov
. 0
7
D
ec
. 0
7
Ja
n.
 0
8
Fe
b.
 0
8
M
ar
. 0
8
A
pr
. 0
8
M
ay
 0
8
Ju
ne
 0
8
Ju
ly
 0
8
A
ug
. 0
8
S
ep
. 0
8
O
ct
. 0
8
N
ov
. 0
8
D
ec
. 0
8
Ja
n.
 0
9
pe
rc
en
ta
ge
 p
oi
nt
s
Greece
Ireland
Italy
Portugal
Belgium
Spain
Austria
Finland
Netherlands
France
 
Source: ECB, https://stats.ecb.int/stats/download/irs/irs/irs.pdf and FT for Jan 09. 
 
Since all these bonds are expressed in the same currency, the euro, these spreads reflect 
a pure default risk (assuming that the German bonds are free of default risk). Thus the 
market now takes the view that the governments of these countries will default on their 
debt in the foreseeable future.  
S 
 How reasonable is such a forecast? It will remain difficult to answer that question. The 
fact that none of the Western European countries have defaulted on their debt in the last 
60 years does not preclude that they will do so in the next 50 years. It is difficult to 
understand, however, why the market (and the rating agencies) forecast a default of the 
Spanish government debt, while it does not make such a forecast for the UK, which has 
experienced a similar buildup of its debt as Spain and whose banking problem is more 
serious than Spain’s.  
My hypothesis is that the widening bond spreads within the eurozone are the result of 
panic in the financial markets. The panic that followed the banking crises has led 
investors into a stampede away from private debt into assets that are deemed safe. These 
are mainly government bonds of a few countries that are perceived to provide safety. 
The US, Germany and possibly France are a few of these countries that for some strange 
reason have been singled out as supplying safety. Other countries do not profit from the 
same ‘panic flight to safety’. This is shown in Figure 2, which presents the levels of the 
government bond rates in the eurozone. We observe a significant decline of the German 
government bond rate by close to 100 bp. Surely it cannot be the case that holding 
German bonds in February 2009 is significantly less risky than a year earlier. But 
Germany was singled out by the market as the country that provided safety. France also 
benefitted from this, but less so. With the exception of Greece and Ireland, the other 
countries kept their bond rates more or less unchanged (compared to a year ago) 
suggesting that these countries were bypassed by panicky investors. Only Greece and 
Ireland saw their bond rates increase significantly over the last year, suggesting that the 
increased spreads of these countries are not only due to panic.  
Figure 2.  
Long term government bond rates in eurozone
3
3,5
4
4,5
5
5,5
6
N
ov
. 0
7
D
ec
. 0
7
Ja
n.
 0
8
Fe
b.
 0
8
M
ar
. 0
8
A
pr
. 0
8
M
ay
 0
8
Ju
ne
 0
8
Ju
ly
 0
8
A
ug
. 0
8
S
ep
. 0
8
O
ct
. 0
8
N
ov
. 0
8
D
ec
. 0
8
Ja
n.
 0
9
pe
rc
en
t
Greece
Ireland
Italy
Portugal
Belgium
Spain
Austria
Finland
Netherlands
France
Germany
 
Source: ECB, https://stats.ecb.int/stats/download/irs/irs/irs.pdf and FT for Jan 09. 
 
 Panic is never a good guide for risk analysis. It distorts prices and gives wrong 
incentives. During the decade preceding the eruption of the financial crisis in August 
2007, rating agencies and market participants, gripped by euphoria, systematically 
underestimated the risk inherent in a wide range of financial assets. Today the panic that 
has gripped them leads to an equally distorted view of the risks involved. Private debt is 
dumped in favour of government debt of just a few countries. How these countries are 
selected is unclear. This selection mechanism is the result of an emotional reaction that 
leads market participants to believe that “it is inconceivable that serious countries like 
the US, Germany or France would ever default on their debt” while other countries are 
deemed to be to be capable of doing such a bad thing. These emotional reactions create 
distortions that affect economic activity in profound ways.  
More specifically, the interest rate spreads faced by southern European countries and 
Ireland are giving the governments of these countries incentives to reduce their efforts 
to stabilise their economies. Extra spending which leads to higher deficits is punished 
by a higher interest cost, discouraging these countries to stimulate their economies. No 
such penalties are imposed on Germany and France.   
In addition, these spreads create a perception of future default crises and impending 
fiscal doom, which impacts on the effectiveness of budgetary policies. We know that 
fears of future default crises reinforce the ‘non-Keynesian’ effects of fiscal policies, i.e. 
when agents fear such future crises, they are more likely to react to budgetary stimulus 
by increasing their savings (see the well-known paper of Giavazzi & Pagano, 1996). As 
a result, budgetary stimulus packages lose their effectiveness.   
The penalties imposed by increasing spreads on southern European counties and Ireland 
also create negative externalities. For example, the rescue of banks in these countries is 
more expensive than in the rest of the eurozone, making it more difficult to resolve the 
banking crisis in these countries. This is likely to lead to further weakening of economic 
activity in these countries with possible feedback again on the banking system, on the 
government budget deficits and on the ratings applied by the rating agencies. 
How should one deal with these distortions and externalities? 
It will remain difficult to prevent cycles of euphoria and panic from affecting 
perceptions of risk in the markets. Authorities can, however, attempt to offset the 
distorting effects these cycles produce. The European Central Bank, in particular, has 
the tools to do just that. Here is my proposal. As the ECB will be forced very soon to 
engage in quantitative easing, it will be buying long-term assets, in particular 
government bonds. It should at that moment, privilege the buying of Irish, Greek, 
Spanish and Italian government bonds. In doing so, it would increase the price of these 
bonds and reduce their yields. Thus such a quantitative easing would tend to reduce the 
spreads in government bonds in the eurozone, and would eliminate the distortions and 
the externalities that these spreads create. It would also make it possible to stimulate the 
economies of all eurozone member countries, benefitting the whole area.   
Clearly this proposal will meet with much resistance. We now increasingly hear the 
story that the market is punishing profligate governments, and rightly so. But why 
should we trust the market judgments any better now than five years ago when the same 
market (orchestrated by rating agencies) completely misjudged the risks that existed in 
the financial markets? When the market was so wrong in the past, why should we 
believe it now and accept its verdict? We should not. The spreads that have been created 
 within the eurozone are largely the result of panic. We can and should correct for the 
distortions and externalities this is creating.  
This being said, it remains the case that Spain, Ireland, Italy and Greece face important 
adjustment problems. These countries have experienced relatively high wage and price 
inflation in the last ten years leading to a loss of competitiveness. This is shown in 
Figure 3. Part of the higher domestic price and wage inflation may be due to the 
Balassa-Samuelson effect, but this is unlikely to be the case in all these countries. Spain 
and Italy, for example, have experienced sluggish productivity growth. It follows that 
these countries will have to go through a period of adjustment aimed at redressing their 
competitive position, very much like Germany did during the first five years of the 
eurozone. This will be a painful process. The overriding problem these countries face 
today, however, is the same as everywhere else, i.e. how to counter the deflationary 
effects of the financial crisis. There is no reason why these countries should be singled 
out to be punished. This punishment will make it more difficult to adjust to the 
deflationary dynamics. It will also not help them in regaining their competitive 
positions.  
 
Figure 3. Relative unit labour costs in the eurozone 
80
90
100
110
120
130
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
R
ea
l e
ffe
ct
iv
e 
ex
ch
an
ge
 ra
te
Ireland
Spain
Italy
Portugal
Netherlands
Greece
France
Belgium
Finland
Austria
Germany
 
Source: European Commission, European Economy. 
 
Reference 
 
Giavazzi, Francesco and Marco Pagano (1996), “Non-Keynesian effects of fiscal policy 
changes: International evidence and the Swedish experience”, Swedish 
Economic Policy Review, May. 


Why should we believe the market this time? ECMI Commentary No. 22, 23 February 2009

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