Recent debt crises have brought the fragility of the Eurozone into focus. It has been argued that members are vulnerable to sudden changes in market sentiment. This column examines how debt markets reacted to an ECB announcement that it would serve as a lender of last resort, finding that recent debt crises have strong self-fulfilling dynamics

Fuertes, A-M.

Kalotychou, E.

Saka, O.

City Research Online

Fuertes, A., Kalotychou, E. & Saka, O. (2015). How did the ECB save the Eurozone without spending a single euro?. VOX, CEPR’s Policy Portal, City Research OnlineOriginal citation: Fuertes, A., Kalotychou, E. & Saka, O. (2015). How did the ECB save the Eurozone without spending a single euro?. VOX, CEPR’s Policy Portal, Permanent City Research Online URL: http://openaccess.city.ac.uk/16903/ Copyright & reuseCity University London has developed City Research Online so that its users may access the research outputs of City University London's staff. Copyright © and Moral Rights for this paper are retained by the individual author(s) and/ or other copyright holders.  All material in City Research Online is checked for eligibility for copyright before being made available in the live archive. URLs from City Research Online may be freely distributed and linked to from other web pages. Versions of researchThe version in City Research Online may differ from the final published version. Users are advised to check the Permanent City Research Online URL above for the status of the paper.EnquiriesIf you have any enquiries about any aspect of City Research Online, or if you wish to make contact with the author(s) of this paper, please email the team at publications@city.ac.uk.How did the ECB save the Eurozone without spending a single euro?file: / / /C| / .../How% 20did% 20the% 20ECB% 20save% 20the% 20Eurozone% 20without% 20spending% 20a% 20single% 20euro.htm[25/04/2017 18:23:47]Published on VOX, CEPR’s Policy Portal (http://voxeu.org)Home > How did the ECB save the Eurozone without spending a single euro?How  did the ECB save the Eurozonew ithout  spending a  single euro?Ana-Maria  Fuertes, Elena Kalotychou, Orkun Saka  26 March 2015Recent debt crises have brought the fragility of the Eurozone into focus. It has been argued that membersare vulnerable to sudden changes in market sentiment. This column examines how debt markets reactedto an ECB announcement that it would serve as a lender of last resort, finding that recent debt crises havestrong self-fulfilling dynamics.aARelatedSelf-fulfilling Eurozone debt crises and the ‘Draghi put’ [1]Marcus Miller, Lei ZhangProcyclical bank risk-taking and the lender of last resort [2]Mark MinkThe European Central Bank as a lender of last resort [3]Paul De GrauweThe Eurozone was never as close to ‘doomsday’  as in the summer of 2012. The debt spreads of theEurozone periphery countries surged and the epicentre of the crisis shifted from Greece and Portugal tolarger economies such as Spain and Italy. On 26 July  2012 the ECB President Mario Draghi eventuallyannounced that the Bank would do “whatever it takes (within [its] mandate)” to save the euro. Shortly after,on 2 August 2012 the ECB declared its intention to perform outright government bond purchases. On 6September 2012 the Bank finally formalised its lender of last resort (LOLR) role via the Outright MoneyTransaction (OMT) programme albeit only for those Eurozone countries who would be eligible forEuropean Stability Mechanism funding; that is, only for solvent but illiquid countries (Wolff 2014). Withhindsight, it is now clear that the OMT has been one of the most effective programmes in the recent historyof central banking, bringing down the credit spreads across the Eurozone without spending a single eurounder its name.Law  and economicsNonetheless, there is still an ongoing case at the hands of the European Court of Justice against the OMTprogramme after the German Constitutional Court judged it to be incompatible with the EU law in January2014.  The German Court’s decision appears to be based on the implicit assumption that the dramaticsurges in credit risk in the Euro region were exclusively a consequence of deteriorating macroeconomicfundamentals; and thus, it was not a ‘business’ of the ECB to interfere with this self-evident relationshipHow did the ECB save the Eurozone without spending a single euro?file: / / /C| / .../How% 20did% 20the% 20ECB% 20save% 20the% 20Eurozone% 20without% 20spending% 20a% 20single% 20euro.htm[25/04/2017 18:23:47]between fundamentals and sovereign debt spreads (see De Grauwe 2014, Giavazzi et al. 2013). In otherwords, it was implicitly assumed that a given state of economic conditions across Eurozone countrieswould always correspond to a single equilibrium interest rate in the bond markets.  Under this premise,every Eurozone sovereign would “deserve” the interest rate it pays on its bonds, which would be utterly tiedto its economic fundamentals. In plain words, the dramatic increase in default risk in many Eurozonecountries had nothing to do with market panic or financial speculation; it was deemed by the Germansceptics as the natural reflection of economic mismanagement in these countries, and hence should becorrected by better management (i.e. austerity and structural reforms). Sinners have to pay! Therefore,according to this logic, there is no need for the ECB to interfere as a LOLR in debt markets since efficientfinancial markets can clearly differentiate between illiquid and insolvent borrowers and provide thenecessary liquidity to the former, or can’t they? Such a fundamental view is difficult to reconcile withtoday’s financial world where, for instance, ’bank runs’ driven by depositor panic are seen as a potentialthreat to banking systems worldwide and central banks are more than welcome to act as LOLR for banks.If bank runs are possible, why is it so difficult to accept the possibility of sovereign debt runs in a currencyunion?Economists’ unease w ith mult iple -equilibriaAs Angeletos and Werning (2006) put it in the introduction of their paper, “It is a love-hate relationship.Economists are at once fascinated and uncomfortable with multiple-equilibria”. We observe a single pricein markets at any given time and are more inclined to assume that this reflects a single outcome which isuniquely decided by a certain set of determinants. This makes life easy for us economists as we now feelmore confident about our own ability of explaining things and predicting future outcomes. If two or moredistinct events were possible under the same set of circumstances, it would seriously hamper theexplanatory and predictive power of our profession; not to mention our self-respect.Status quo in mainstream economics may change though, albeit slowly. Few would remember howelegantly Paul Krugman (1996) defended the first-generation models of currency crises which at the timeput all the blame on the governments and on mismanagement of economic indicators. A few years later,he would come to terms with the second-generation models of currency crises, due to Obstfeld (1996),which rationalised the possibility that for countries with an intermediate set of fundamentals, bad marketexpectations might validate themselves by raising interest rates and forcing an otherwise-solventgovernment to leave its currency peg. Krugman’s eventual confession was also elegant: “I was wrong,Maury Obstfeld was right” (1999).  Eurozone  fragility hypothesisIn a recent empirical paper, we revisit a similar debate in the context of recent Eurozone debt crises byexamining whether Paul De Grauwe was right (Saka et al. 2015).1 As well known by the readers ofVoxEU, De Grauwe is the first economist to contend that the same arguments that rationalise self-fulfillingdebt runs as serious threats to developing countries – à la Calvo (1988) – apply to country members of acurrency union as well. De Grauwe reasons that the loss of power in printing the currency in whichindividual states borrow would bring fragility to Eurozone members and render them vulnerable to thesudden switches in market sentiments. But such fragility could be prevented if the ECB takes on the LOLRrole (De Grauwe 2011). Thus the OMT programme, even under strict conditions that makes it applicableonly to illiquid but solvent countries, ought to be able to avert the self-fulfilling panic even without actuallyinterfering in the market (Giavazzi et al. 2013). This is indeed the case as borne out by the calming-downeffect of the policy even though it was never exercised.It is clear that the change in the ECB’s policy stance first signalled by Draghi’s ’whatever-it-takes’ speechHow did the ECB save the Eurozone without spending a single euro?file: / / /C| / .../How% 20did% 20the% 20ECB% 20save% 20the% 20Eurozone% 20without% 20spending% 20a% 20single% 20euro.htm[25/04/2017 18:23:47]represents the bank’s LOLR role in Eurozone debt markets. In our paper, we examine the debt markets’behaviour around this date to gauge whether previously-detected contagion in the region had a self-fulfilling component. If the contagion was only due to fundamentals and solvency concerns, one would notexpect the OMT to halt it.2To sterilise the impact of the ECB’s policy change, we analyse the daily credit default swap (CDS) spreadsof 10 Eurozone countries over two one-year windows around the implicit OMT announcement. Through aprincipal component analysis, we show that commonality in Eurozone spreads significantly increased post-announcement while there seemed to be additional factors affecting the sovereign spreads in aheterogeneous way before the policy. A pure fundamentalist interpretation of these findings would be thatmarkets perceived the OMT as a debt guarantee scheme and hence, the commonality in spreads mighthave increased since Eurozone members now shared responsibility for each other’s debt through theECB. If this were true, the OMT must have distorted the relation between debt spreads and fundamentalsby inflating spreads in ’virtuous’ countries with good fundamentals and deflating them in the ’sinner’countries with bad fundamentals. To assess this, we regress the quarterly CDS spreads of Euro membersagainst key macroeconomic indicators in the credit risk literature.Surprisingly, Figure 1 illustrates in its upper panel that sovereign spreads that were most out of sync withfundamentals belonged only to the pre-announcement quarters and only to periphery countries. Even afterdropping the bailed-out countries assuming that their spreads may have lost connection with fundamentalsdue to their loss of market access, we still get the same results (lower panel in Figure 1) but this time onlyfor Spain and Italy before the OMT policy. It seems that, before the ECB assumed a LOLR position, thesecountries’ spreads were pushed above the levels rationalised by their fundamentals.Figure  1 . Scatterplots and OLS regression line for Eurozone CDS spreads vs. macro fundamentals frommid-2011 to mid-2013Note: The four graphs in the upper panel are based on pooled quarterly observations for 10 Eurozonecountries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal and Spain)and the ones in the lower panel are for the same set of countries excluding Ireland and Portugal. The Y-How did the ECB save the Eurozone without spending a single euro?file: / / /C| / .../How% 20did% 20the% 20ECB% 20save% 20the% 20Eurozone% 20without% 20spending% 20a% 20single% 20euro.htm[25/04/2017 18:23:47]axis represents the quarterly CDS spreads and the X-axis represents the corresponding macroeconomicindicators of these countries over the two-year period from mid-2011 to mid-2013.Source: Saka et al. (2015); authors’ calculations based on data from Datastream, Oxford Economics,World Development Indicators (World Bank) and OECD.We also check the explanatory power of these macro indicators on CDS spreads in two separate periods.Our results show that fundamentals matter in explaining sovereign CDS spreads in both windows but theybecome much more influential after the OMT policy. This does not support the view that debt spreads hadalready been well-aligned with fundamentals and the OMT (misconceived as a blanket guarantee scheme)distorted the relationship.Our paper goes on to investigate the presence of various versions of seemingly-non-fundamental type ofcontagion links across Eurozone and stand-alone European countries which print their own currencies.We find that such contagion links were strongest within the Eurozone and were significantly dampened bythe OMT policy which implies that previously-detected contagion in the region had a significant self-fulfilling component.ConclusionsPaul De Grauwe was right in his diagnosis of the Eurozone as a fragile region and relatedly, of the recentdebt crises as having a strong element of self-fulfilling dynamics. The OMT has been an effective medicineto overcome the fragility. However, these reflections should not mask the fact that the euro is still anincomplete construct. Hopefully a day will arrive in the near future when the Eurozone is complementedwith a fiscal authority with possibly centralised tax and redistributive powers so that it eventually evolvestowards a currency with a single political and fiscal union. Given the strong German resistance to the OMT,no one can be fully sure if Draghi’s bold initiative will be able to survive until that day!ReferencesAngeletos, G M and Werning, I (2006),“Crises and prices: Information aggregation, multiplicity andvolatility” The American Economic Review 96(5), 1720-36.Beirne, J and M Fratzscher (2013), “The pricing of sovereign risk and contagion during the Europeansovereign debt crisis”, Journal of International Money and Finance 34, pp. 60–82.Calvo, G A (1988) "Servicing the public debt: The role of expectations", The American Economic Review78(4), 647-61.De Grauwe, P (2011), “The European Central Bank as a lender of last resort [4]", VoxEU.org, 18 August.De Grauwe, P (2014), "Economic theories that influenced the judges of Karlsruhe [5]", VoxEU.org, 13March.Giavazzi F, R Portes, B Weder di Mauro and C Wyplosz (2013), "The wisdom of Karlsruhe: The OMTCourt case should be dismissed [6]", VoxEU.org, 12 June.Krugman, P (1996) “Are currency crises self-fulfilling?” NBER Macroeconomics Annual, 11, 345-78.Krugman, P (1999) “Balance Sheets, the transfer problem and financial crises", International Tax andPublic Finance 6(4), 459-72.How did the ECB save the Eurozone without spending a single euro?file: / / /C| / .../How% 20did% 20the% 20ECB% 20save% 20the% 20Eurozone% 20without% 20spending% 20a% 20single% 20euro.htm[25/04/2017 18:23:47]Obstfeld, M (1996) “Models of currency crises with self-fulfilling features”, European Economic Review 40,1037-1047.Saka, O, A M Fuertes, and E Kalotychou (2015) “ECB Policy and Eurozone Fragility: Was De GrauweRight? [7]”, Working Paper.Wolff, G B (2014) “The OMT programme was justified but the fiscal union question remains, Comments on'Did the German court do Europe a favour? [8]’ by A Mody”, bruegel.org, 15 July.Footnotes[1] An earlier version of the paper can be found on http://www.ceps.eu/book/ecb-policy-and-eurozone-fragility-was-de-grauwe-right [9].[2] There is a growing literature arguing that investors became more sensitive to fundamentals in theEurozone during the crisis period, a phenomenon that has been often formalised as ’wake up calls’ orfundamental contagion (for example, see Beirne & Fratzscher 2013).aATopics:  EU policies [10]Tags:  ECB [11], lender of last resort [12], Eurozone crisis [13], debt [14]RelatedSelf-fulfilling Eurozone debt crises and the ‘Draghi put’ [1]Marcus Miller, Lei ZhangProcyclical bank risk-taking and the lender of last resort [2]Mark MinkThe European Central Bank as a lender of last resort [3]Paul De GrauweSource URL: http://voxeu.org/article/how-did-ecb-save-eurozone-without-spending-single-euroLinks:[1] http://voxeu.org/article/self-fulfilling-eurozone-debt-crises-and-draghi-put[2] http://voxeu.org/article/procyclical-bank-risk-taking-and-lender-last-resort[3] http://voxeu.org/article/european-central-bank-lender-last-resort[4] http://www.voxeu.org/article/european-central-bank-lender-last-resort[5] http://www.voxeu.org/article/economic-flaws-german-court-decision[6] http://www.voxeu.org/article/wisdom-karlsruhe-omt-court-case-should-be-dismissed[7] http://ssrn.com/abstract=2459882[8] http://www.bruegel.org/nc/blog/detail/article/1391-the-omt-programme-was-justified-but-the-fiscal-union-question-remains[9] http://www.ceps.eu/book/ecb-policy-and-eurozone-fragility-was-de-grauwe-right[10] http://voxeu.org/content/topics/eu-policies[11] http://voxeu.org/taxonomy/term/53[12] http://voxeu.org/taxonomy/term/820[13] http://voxeu.org/taxonomy/term/2277[14] http://voxeu.org/taxonomy/term/1441

How did the ECB save the Eurozone without spending a single euro?

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