Following the financial crisis, already ten years old, Europe was hit by a severe sovereign debt crisis that challenged the European institutions. Should the ECB have responded to the crisis with the powerful tools of monetary issuance? Or should instead the solution of the crisis be left to the fragile European fiscal institutions? At the heart of these questions is the issue of whether the sovereign debt crisis in Europe was due to weak fundamentals or to coordinated expectations. Whether the answer is fundamentals or expectations could mean that either the ECB was right in intervening massively, targeting low sovereign debt spreads, or the German Constitutional Court was right in questioning that same intervention. The answer may very well be that both fundamentals and expectations are to blame.
The importance of fundamentals
Portugal, my country, was one of the countries more severely hit by the sovereign debt crisis. And fundamentals did certainly play a role. I could see that role being played as I taught open economy macro at Universidade Catolica, in Lisbon, year after year.
I have been teaching a course in international macro since the early 1990s. I always start by looking at the figures for the balance of payments in Portugal. The first time I taught the course, back in 1993, and looked at those numbers, the Portuguese net foreign debt was -3% of GDP, i.e. net foreign assets were positive (public debt was 55% of GDP).
Foreign deficits started going up in the mid nineties. Foreign debt in 1999, at the start of the Euro, was already 34% of GDP, still quite low, but the current account deficit was close to 10%.
Since then, every year, on the first day of class, I would look at the numbers, and the debt was higher than the previous year deficit, and the deficit was equally high. After a while, I did not need to look at the numbers any longer. The debt would be up by more than 5% of GDP, closer to 10%, year after year.
Then, came the years without growth, and the deficits were even higher. Finally came the financial crisis and with it a sequence of public deficits above 10% of GDP, the debt hidden in public companies or in public-private partnerships adding up to the total public debt (130% in 2013).
By the end of 2009, the foreign debt was close to 110% of GDP and the current account deficit was still 9% of GDP. Then spreads went up.
The potential role for expectations
Portugal was not the only country in Europe with weak fundamentals at the onset of the sovereign debt crisis. But was there also a role for expectations in triggering the crisis? How much of the crisis could have been caused by self-fulfilling expectations on default?
I don’t think we can answer these questions without using. There are two main ways in which expectations may matter. One is liquidity (I’ll call it Cole and Kehoe). Governments issue short-term debt, and they have long-term assets, their entitlement to tax revenues. This maturity mismatch could induce a sovereign debt crisis driven by a run on sovereign debt, just as maturity mismatches in banking lead to bank runs.1
A second way expectations may matter is through interest rates that affect the service of debt (call it Calvo). If expectations are good, interest rates are low, and consequently servicing costs are also low; default does not occur. However, if investors expect high default risk, they ask for high interest rates to compensate for this, which drives up servicing costs and can induce default.2
Both theoretic explanations of a role for expectations, Cole and Kehoe or Calvo, are compelling but the modeling of both is remarkably fragile. Whether the models can produce expectation-driven outcomes depends critically on the specifics of the model, on the timing of moves of borrowers and lenders and on the decisions they get to make.3 Which theories are correct in terms of these specifics? There is unfortunately no real way to tell directly from data. Still, the large swings in spreads, and the effect of a mere statement of intensions by Mario Draghi are good evidence of multiplicity.
In some of my own work, “Self-Fulfilling Debt Crises with Long Stagnations” with João Ayres, Gaston Navarro, and CREDO member, Juan Pablo Nicolini, we argue that the role of expectations is more robust if the world we live in is one with good and bad times, i.e., long periods of high growth followed by long periods of stagnation. During good times, default is unlikely, and expectations can’t drive the outcomes, but when countries enter long stagnations default is much more likely, and expectations can be critical. Portugal has faced a fifteen-year long stagnation with high levels of debt both public and foreign. Fundamentals did certainly play a role there. But our work can also help us argue that expectations may have played a key role in triggering the crisis.
Pedro Teles
Professor, Católica Lisbon School
of Business and Economics
References
Aguiar, M. and G. Gopinath. 2006. “Defaultable Debt, Interest Rates and the Current Account,” Journal of International Economics 69, 64–83.
Arellano, C. 2008. “Default Risk and Income Fluctuations in Emerging Economies,” American Economic Review 98, 690–712.
Ayres, J., G. Navarro, J. P. Nicolini, and P. Teles. 2015. “Self-Fulfilling Debt Crises with Long Stagnations,” Working Paper 723, Federal Reserve Bank of Minneapolis.
Calvo, G. A. 1988. “Servicing the Public Debt: The Role of Expectations,” American Economic Review 78, 647–661.
Cole, H. L. and T. J. Kehoe. 2000. “Self-Fulfilling Debt Crises,” Review of Economic Studies 67, 91–116.
Notes
1 Cole and Kehoe (2000) examine this type of crisis.
2 See Calvo (1988).
3 See, for example, Aguiar and Gopinath (2006) or Arellano (2008)
