As the European Central Bank prepares to dig deeper for the billions of Euros to bail out Spain and Italy if necessary, NECSI scientists asked whether the Eurozone’s debt crisis was actually the result of flawed fiscal policies or blind panic in the markets. Their answer is: yes, the debt crisis is real, but that market overreactions made it much worse by driving interest rates higher at a critical time, leading policy-makers to over-react. The repercussions include the halving of Greek debt a year earlier than necessary had the markets been in equilibrium.
For the first time, NECSI’s study quantitatively demonstrates how interest rates implicitly behave according to sovereign debt. The bond market effectively has a pre-set debt threshold it expects a given country to default at. For each country, this value is always present in interest rates, even when default is unlikely. As sovereign debt approaches the threshold, however, interest rates rise until mounting pressure triggers a default. This is the pressure which forced Greece, Ireland, and Portugal to accept bailouts and adopt austerity measures, and which is currently mounting on Italy and Spain.
M. Lagi, Y. Bar-Yam, The European debt crisis: Defaults and market equilibrium. NECSI report, Sept. 27, 2012.