Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone

LICOS Discussion Paper No. 304/2012

28 Pages Posted: 1 Feb 2012

See all articles by Paul De Grauwe

Paul De Grauwe

CESifo (Center for Economic Studies and Ifo Institute for Economic Research); London School of Economics & Political Science (LSE); Centre for Economic Policy Research (CEPR)

Yuemei Ji

KU Leuven - Faculty of Business and Economics (FEB)

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2012

Abstract

We find evidence that a significant part of the surge in the spreads of the PIGS countries in the Eurozone during 2010-11 was disconnected from underlying increases in the debt to GDP ratios, and was the result of negative market sentiments that became very strong since the end of 2010. 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 were equally high and increasing in these countries. We interpreted this evidence as validating the hypothesis formulated in De Grauwe(2011) according to which government bond markets in a monetary union are more fragile and more susceptible to self-fulfilling liquidity crises than in stand-alone countries. We argue 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.

Suggested Citation

De Grauwe, Paul and De Grauwe, Paul and Ji, Yuemei, Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone (January 1, 2012). LICOS Discussion Paper No. 304/2012 , Available at SSRN: https://ssrn.com/abstract=1996396 or http://dx.doi.org/10.2139/ssrn.1996396

Paul De Grauwe (Contact Author)

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Yuemei Ji

KU Leuven - Faculty of Business and Economics (FEB) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

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