There is a strong perception that countries that introduced austerity programs in the Eurozone were somehow forced to do so by the financial markets. Is this perception based on a reality? Figure 1 shows the average interest rate spreads in 2011 on the horizontal axis and the intensity of austerity measures introduced during 2011 as measured by the Financial Times on the vertical axis. It is striking to find a very strong positive correlation.
The higher the spreads1 in 2011 the more intense were the austerity measures. The intensity of the spreads can be explained almost uniquely by the size of the spreads (the R-squared is 0.97). Note the two extremes. Greece was confronted with extremely high spreads in 2011 and applied the most severe austerity measures amounting to more than 10% of GDP per capita. Germany did not face any pressure from spreads and did not do any austerity.
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. Figure 2 provides the evidence. On the vertical axis we show the change in the spreads in the Eurozone from the middle of 2012 (when the ECB announced its program) to the beginning of 2013. On the horizontal axis we present the initial spread, i.e. the one prevailing in the middle of 2012. We find a surprising phenomenon. The initial spread (i.e. in 2012Q2) explains almost all the subsequent variation in the spreads.
Thus the country with the largest initial spread (Greece) experienced the largest subsequent decline; the country with the second largest initial spread (Portugal) experienced the second largest subsequent decline, etc. In fact the points lie almost exactly on a straight line going through the origin. The regression equation indicates that 97% of the variation in the spreads is accounted for by the initial spread. 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.
How well did this panic-induced austerity work? Countries that imposed the strongest austerity measures also experienced the strongest declines in their GDP. This result is in line with the IMF’s recent analysis (IMF 2012).
Read more: Panic-driven austerity in the Eurozone and its implications | vox
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