European Central Bank staffers conclude that market-based valuation of sovereign risk is a valid way to discipline fiscal policy especially but not only in times of crisis.
The implication, a trio of economists write, is that theres little justification for the claim that governments faced with high risk premiums during the crisis deserve the solidarity of other governments in the euro area. Two of the authors — Ludger Schuknecht and Guido Wolswijk– are from the ECB. The third, Juergen von Hagen, is from University of Bonn.
The timing of the paper, posted on the ECBs Web site this week, is noteworthy amid debate over how European governments might craft an assistance package to Greece to help that country deal with its fiscal crisis. A key message is that governments need to have even sounder fiscal policies during expansions to avoid the costs of borrowing during crises. Greece has been criticized for not doing enough to reform its economy and finances last decade when its economy grew above the euro zones average.
The authors conclude that bond yield spreads over U.S. and German benchmarks can still largely be explained on the basis of economic principles during the crisis. In addition, financial markets penalize fiscal imbalances much more strongly since the Lehman default in September 2008.
Whereas before Lehman Brothers an additional percent of deficit over Germanys resulted in a 3.5 basis point widening in yield spread, after Lehman the spread effect ballooned to 12.6 basis points, the authors estimate.
The crisis thus seems to have caused a significant change in the markets assessment of the governments fiscal performance and the cost of profligate fiscal behavior has increased considerably, they wrote.
For Greece, Ireland and Portugal relatively weak fiscal performance explains almost or more than half of the increase in the spreads during the crisis, the economists write.