Panic-driven austerity in the Eurozone and its implications

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Eurozone policy seems driven by market sentiment. This Paul De Grauwe and Yuemei Ji argue, in a recent VOXEU communique (Feb. 21^st), that fear and panic led to excessive, and possibly self-defeating, austerity in the south while failing to induce offsetting stimulus in the north. The resulting deflation bias produced the double-dip recession and perhaps more dire consequences. As it becomes obvious that austerity produces unnecessary suffering, millions may seek liberation from ‘euro shackles’.

There is a strong perception that countries that introduced austerity programs in the Eurozone were somehow forced to do so by the financial markets. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.

The next question that arises is whether the judgment of the market (measured by the spreads) about how much austerity each country should apply was the correct one. There are essentially two theories that can be invoked to answer this question. According to the first theory, the surging spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals.

Another theory, while accepting that fundamentals matter, recognizes that collective movements of fear and panic can have dramatic effects on spreads. These movements can drive the spreads away from underlying fundamentals, very much like in the stock markets prices can be gripped by a bubble pushing them far away from underlying fundamentals.

The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.

This decision of the ECB provides us with an interesting experiment to test these two theories about how spreads are formed.   Thus it appears that the only variable that matters to explain the size of the decline in the spreads since the ECB announced its determination to be the lender of last resort is the initial level of the spread. Countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads – a remarkable feature. 

A large component of the movements of the spreads since 2010 was driven by market sentiments. These market sentiments of fear and panic first drove the spreads away from their fundamentals. Later as the market sentiments improved thanks to the ECB, these spreads declined.

Three conclusions can be drawn:  the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushing spreads artificially high and forced cash-strapped nations into intense austerity; Panic and fear are not good guides for economic policies as the quick and intense austerity  led to deep recessions, but did not help to restore sustainability of public finances; and financial markets did not signal northern countries to stimulate their economies, thus introducing a deflationary bias that lead to the double-dip recession.

The intense austerity programs that have been dictated by financial markets create new risks for the Eurozone. While the ECB 2012 decision to be a lender of last resort in the government bond markets eliminated the existential fears about the future of the Eurozone, the new risks for the future of the Eurozone now have shifted into the social and political sphere. As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the people who have been thrown into unemployment and poverty, resistance against these programs associated with the euro is likely to increase.

www.voxeu.org/article/panic-driven-austerity-eurozone