Self-fulfilling crises in the Eurozone: An empirical test

TLDR

The study tests whether Eurozone government bond markets are more fragile and prone to self‑fulfilling liquidity crises than those of stand‑alone countries. Evidence shows that the 2010–11 surge in peripheral Eurozone bond spreads was largely driven by self‑fulfilling market sentiment rather than debt‑to‑GDP increases, leading to potential bad equilibria, while similar debt levels in stand‑alone countries did not trigger such concerns.

Abstract

We test the hypothesis that the government bond markets in the Eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We find evidence that a significant part of the surge in the spreads of the peripheral Eurozone countries during 2010–11 was disconnected from underlying increases in the debt to GDP ratios and fiscal space variables, and was associated with negative self-fulfilling market sentiments that became very strong since the end of 2010. We argue that this can drive member countries of the Eurozone into bad equilibria. We also find evidence that after years of neglecting high government debt, investors became increasingly worried about this in the Eurozone, and reacted by raising the spreads. No such worries developed in stand-alone countries despite the fact that debt to GDP ratios and fiscal space variables were equally high and increasing in these countries.