Explaining Sovereign Spreads in the Euro Area: The Role of Contagion, Fiscal Sustainability and Multipla Equilibria

Abstract

Several recent contributions on the euro crisis have highlighted the presence of discontinuity points in the link between sovereign spreads and economic fundamentals. The most puzzling evidence is the relatively stable environment that has characterized the sovereign bond market despite growing macroeconomic imbalances in the euro area. The abrupt surge in yields has been interpreted as an expression of various form of “contagion” that led the financial market to reassess the risk profile of sovereign bonds. On the ground of the theory of sovereign crisis we propose an empirical model that explains the outbreak of the crisis and brings new evidence on the role played by debt sustainability in the contagion to other peripheral bond markets. The empirical evidence broadly confirms the role played by various form of contagion but hands back the responsibility of the euro crisis mainly in the hands of the policy makers both at domestic and at the European level. Fiscal sustainability presides over the switching between regimes characterized by different sensitivities of the financial markets to economic news. The deterioration of the fiscal outlook caused by fiscal profligacy and the recapitalization of ailing banks together with the lack of growth-enhancing structural reforms and the wrongly timed ECB’s rate hikes in 2011 seem to be the ultimate causes of the near collapse of the Euro area.