The Macroeconomic Effects of the Sovereign Debt Crisis in the Euro Area

Abstract

Since the spring of 2010 tensions in the government bond markets in the euro-area have led to diverging dynamics in the cost of loans and credit developments among euro-area countries. These heterogeneous credit conditions, together with fiscal consolidations in some countries, have led to diverging trends in economic activity and employment. This paper studies the macroeconomic effects of the sovereign debt crisis focusing on a subset of euro-area countries using a Factor Augmented Vector Autoregressive (FAVAR) model. The analysis suggests that the sovereign tensions have led to an increase in the cost of new loans and a contraction in credit which has been particularly strong in the countries most affected by the crisis. The higher cost of credit and the contraction in lending have exerted a negative and significant effect on industrial production in both the peripheral and core countries. In the latter countries, the contraction in economic activity has reflected the strong trade link with the peripheral countries. The findings are robust to an alternative transformation of the data and measure of sovereign tensions.