Mispricing of Sovereign Risk and Macroeconomic Stability in the Eurozone*

Abstract

Abstract This article presents evidence that a significant part of the surge in the spreads of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries in the eurozone during 2010–11 was disconnected from underlying increases in the debt‐to‐GDP (gross domestic product) ratios, and was the result of negative market sentiments that became very strong since the end of 2010. It is argued that the systematic mispricing of sovereign risk in the eurozone intensifies macroeconomic instability, leading to bubbles in good years and excessive austerity in bad years.