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All in: Market expectations

of eurozone integrity in the
sovereign debt crisis
a b
Michele Chang & Patrick Leblond
a
Department of European Political and Administrative
Studies, College of Europe, Dijver 11, BE-8000, Bruges,
Belgium
b
Graduate School of Public and International Affairs,
University of Ottawa, 120 University Private, #6021,
Ottawa, ON K1N 6N5, Canada
Published online: 08 Aug 2014.

To cite this article: Michele Chang & Patrick Leblond (2014): All in: Market expectations
of eurozone integrity in the sovereign debt crisis, Review of International Political
Economy, DOI: 10.1080/09692290.2014.941905

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http://dx.doi.org/10.1080/09692290.2014.941905

All in: Market expectations of eurozone

integrity in the sovereign debt crisis
Michele Chang1 and Patrick Leblond2
Downloaded by [College of Europe], [Michele Chang] at 07:52 21 August 2014

1
Department of European Political and Administrative Studies, College of
Europe, Dijver 11, BE-8000, Bruges, Belgium; 2Graduate School of Public and
International Affairs, University of Ottawa, 120 University Private, #6021,
Ottawa, ON K1N 6N5, Canada

ABSTRACT
The behaviour of sovereign bond investors stands at the heart of the euro
area debt crisis. By pushing upward the yields on the government debts of
member states standing in the eurozone’s periphery, investors caused, in a
self-fulfilling way, the crisis that ultimately threatened the eurozone’s
integrity and the euro’s survival. So how do we explain the behaviour of
market investors before, during and after the eurozone’s sovereign debt
crisis? Why did investors not discriminate in their pricing of eurozone
sovereign bonds before the crisis? Why did they abruptly change their
minds in 2010? And why have they gradually felt reassured enough from
mid-2011, depending on the country, to ask for significantly lower yields
on sovereign bonds? To answer these questions, the paper argues that
investors’ confidence rests to a large extent on the expectation of the
eurozone’s solidarity, which is why large-scale multilateral solutions
coming from the euro area were more successful in resolving the crisis than
unilateral ones coming primarily from the debtor countries. As a result,
this paper improves our understanding of the international political
economy of financial (currency, bank and debt) crises by looking at the
particular case of a monetary union with a single currency.

KEYWORDS
Financial crisis; eurozone; European monetary union; sovereign bonds;
investors; market behaviour; single currency.

Ó 2014 Taylor & Francis

 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

INTRODUCTION
The interdependent economies of the euro area have long sought ways
to reduce instability in international financial markets in order to
ensure that international economic transactions would be able to thrive.
A key element was currency stability, as exchange rate fluctuations
threatened to wreak havoc on trade and investment. While a myriad of
economic and political rationales for European Economic and Monetary
Union (EMU) have been put forward (e.g., Eichengreen, 1993; Moravc-
sik, 1998; Sandholtz, 1993), an important component was the need to
remove the threat of currency crises that were caused by self-fulfilling
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speculative attacks. Rising capital mobility made it increasingly diffi-

cult for governments to battle the practically limitless resources of cur-
rency markets, propelling European governments towards abandoning
their fixed exchange rate system (the European Monetary System) in
favour of a single currency. Indeed, membership in a monetary union
was supposed to offer its members protection from market speculation
and provide the stability needed for the single market to function
optimally.
While the euro removed exchange rate risk, market speculation has
nevertheless returned to threaten the financial stability of the countries in
the periphery of the euro area through speculation on government bonds.
If the elimination of currency speculation was considered one of the ben-
efits associated with EMU, the exchange rate constraint imposed by mon-
etary integration is now viewed negatively in the context of a debt crisis.
This is because affected member states have lost control over policy tools
like currency devaluation, debt monetization and the ability to provide
liquidity to banks (e.g., De Grauwe and Ji, 2013). As a result, euro area
countries, especially peripheral ones, have been compared to emerging
market countries in that both issue public debt in currencies over which
they have no control: the euro in the former and a foreign currency in the
latter. And like emerging market economies, euro area economies in the
periphery enjoyed very cheap access to capital during the good years
and a quick reversal (known as a ‘sudden stop’) once the sovereign debt
crisis began.
So how do we explain the behaviour of market investors before, during
and after the eurozone’s sovereign debt crisis?1 Why did investors not
discriminate in their pricing of eurozone sovereign bonds before the cri-
sis? Why did they abruptly change their minds in 2010? And why have
they gradually felt reassured enough from mid-2011, depending on the
country, to ask for significantly lower yields on sovereign bonds?
These questions are important for two reasons. First, the behaviour of
sovereign bond investors stands at the heart of the euro area debt crisis.
By pushing upward the yields that they expected to finance government

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 C HANG AND LEBLOND: A LL IN

debts, investors caused, in a self-fulfilling way, the crisis that ultimately

threatened the eurozone’s integrity and the euro’s survival. Therefore, a
better understanding of bond investors’ behaviour in the euro area will
help in devising better policies to prevent future crises. Second, answer-
ing the questions above will improve our understanding of the interna-
tional political economy of financial (currency, bank and debt) crises by
looking at the particular case of a monetary union with a single currency.
Theories on the political economy of currency crises and debt crises pro-
vide insights on the behaviour of financial markets; specifically, the
potential disconnect between a country’s economic fundamentals and
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the pricing of its currency or sovereign debt indicates the need for politi-
cal in addition to economic analysis so as to understand market behav-
iour during crisis periods (Bernhard and Leblang, 2006; Chang, 2004;
Leblang and Satyanath, 2006). Such analysis has been applied to debt cri-
ses in emerging markets (Calvo, 1998; Cole and Kehoe, 1996; Giavazzi
and Pagano, 1990), but the size and level of development of the euro area
make the latter a critical case study from the standpoint of theory as well
as policy.
In response to the questions at the heart of this article, we argue that
during the first years of the euro’s existence, sovereign bond investors
apparently underpriced risk, owing to their belief that euro area coun-
tries could be evaluated as a set and no longer required country-specific
analyses. This process actually began before the start of EMU and
occurred despite continued economic divergence between euro area
member states. The speculation from early 2010 onward reflects not only
the varying economic fundamentals of individual eurozone member
states but also, and more importantly, the growing concern for the integ-
rity of the euro area itself. Therefore, Mario Draghi’s July 2012 ‘whatever
it takes’ pledge to save the euro area ultimately calmed bond investors
down in a way that bailouts and the conditionality programmes that
accompanied them had not managed to do. Markets sought a large-scale
multilateral solution coming from the euro area rather than a unilateral
one coming primarily from the debtor countries. Market confidence in
the euro area has therefore always rested to a large extent on the expecta-
tion of its solidarity.
To develop this argument, the article is structured as follows. The first
section lays out the empirical puzzle: despite substantial differences in
the state of euro area economies, bond yields were negligible prior to
2008 but varied enormously afterwards, especially between early 2010
and mid-2012. The next section details the argument regarding the shift
in investors’ expectations about the eurozone’s integrity. The following
section provides empirical support for the argument developed herein,
drawing on brief case studies of the crisis countries. Finally, the

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

conclusion considers the implications for the resolution of the euro area
crisis and the policy lessons that can be extrapolated.

SOVEREIGN BOND INVESTORS’ BEHAVIOUR IN THE

EURO AREA
This section demonstrates the general evolution of bond market behav-
iour in the euro area since its inception. Prior to the euro’s introduction,
there was strong economic convergence in order to comply with the
Maastricht Treaty’s convergence criteria (on inflation, interest rates,
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debt and deficit levels and exchange rates), but afterwards, the reason
for the continued bond market convergence became more ambiguous.
Once the Greek debt crisis began in late 2009, however, bond markets
began to sharply distinguish between euro area countries. An impor-
tant source of market complacency in the earlier period and market
speculation in the second was market expectations about the integrity
of the euro area.

Pre-crisis bond market behaviour

EU member state economies had been gradually converging for decades,
largely due to pressure from European monetary cooperation. In the
1980s and 1990s, the European Monetary System (EMS) contributed to
stabilized exchange rates and improved price stability, which lowered
interest rates across Europe (Giavazzi and Pagano, 1988) towards
German levels. The 1993 Maastricht Treaty’s criteria on debt (not to
exceed 60 percent of gross domestic product, GDP) and deficit levels (not
to exceed 3 percent of GDP) contributed further to the convergence of
economic conditions across Europe by making their attainment a precon-
dition of EMU membership. Fiscal probity of euro area members was
expected to continue after the start of EMU under the Stability and
Growth Pact (SGP).2 Moreover, the Maastricht Treaty’s no-bailout clause
was expected to further promote convergence via market discipline, as
the bailout of an EMU member state would be legally prohibited (e.g.,
Dornbusch, 1997).3 Finally, it was assumed that after EMU began, the use
of the single currency would stimulate intra-eurozone trade and spur fur-
ther economic convergence because of the endogeneity of international
trade and business cycles (Frankel and Rose, 1998).
Bond yields reflected not only the actual economic convergence that
occurred but also the expectation of convergence in anticipation of the
emergence of the euro area. In the mid-1990s, sovereign bond investors
facilitated the entry into the euro area of many member states by reduc-
ing government bond yields. This was because EU institutions, especially

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 C HANG AND LEBLOND: A LL IN

the European Commission and the European Monetary Institute, had

managed to increase the certainty that the euro would see the light of
day as they were putting in place the operational building blocks for the
single currency (Leblond, 2004).4 The expected adoption of the euro com-
bined with the removal of exchange rate risk contributed to lower interest
rates across the EU (ECB, 2003: 22). By making it cheaper to finance their
public debts, bond investors thereby helped governments in Italy, Spain
and Portugal meet the Maastricht criterion on fiscal deficits on time for
joining the euro on 1 January 1999.5 As such, bond market expectations
became self-fulfilling. Indeed, as intra-euro exchange rate risk was now
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removed, markets viewed the euro area as a whole when allocating port-
folios, as governments issued larger volumes of securities and increased
liquidity in euro-denominated bonds (Andersson et al., 2006: 35). There-
fore, the expectation of the introduction of the euro helped to reduce
interest rates ahead of the euro’s actual introduction.
Despite the continued economic divergence between member states
after EMU began, market assumptions about the euro area’s integrity
continued, which were reflected in the pricing of sovereign bonds. The
breaching of the SGP had little to no impact on investors’ perceptions
when, in November 2003, France and Germany blocked the EU from
imposing financial sanctions on them for having excessive deficits (i.e.,
above 3 percent of GDP). The SGP’s reform in March 2005 only
enshrined the new modus operandi (for details, see Heipertz and Verdun,
2010).
Thus, the onus was now squarely on sovereign bond investors to keep
eurozone governments in check when it came to the sustainability of
their public finances. If the risk that a member state defaults on its debt
were to increase as a result of cumulated fiscal deficits, then sovereign
bond investors would demand a risk premium in the form of higher
interest rates (or yields) or even refuse to lend any more funds to a profli-
gate member state. This is the so-called ‘market discipline hypothesis’.
According to several studies, bond investors apparently priced credit (or
default) risk differently in the yields they demanded for financing euro
area sovereign debt before the crisis (Bernoth and Erdogan, 2012; Bernoth
et al., 2012; Maltritz, 2012; Manganelli and Wolswijk, 2009).
However, sovereign bond investors did not react to the November
2003 Council vote on the Excessive Deficit Procedure for France and Ger-
many, having already anticipated this outcome because they understood
the SGP’s political nature (Leblond, 2006). Despite the SGP reform and
indications of diverging economic conditions in member states, govern-
ment bond market yields of similar maturity traded ‘as close substitutes
with yield spreads typically below 50 basis points in all cases’ (European
Commission, 2008: 95, emphasis added). Markets did not differentiate
strongly between euro area member states, despite official recognition of

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

fiscal divergence and the weakening of the SGP that was designed to
keep member state deficit levels in check. Thus, a number of authors
have found that market discipline was insufficient or ‘underpriced’ in
the period before the crisis in that it did not account for economic differ-
ences between euro area countries (Aizenman et al., 2013; Arghyrou and
Kontonikas, 2011; Beirne and Fratzscher, 2013; De Grauwe and Ji, 2013;
Ghosh et al., 2013; Gibson et al., 2012).6 Although bond yields were some-
what responsive to governments’ fiscal performance, they were much
more mitigated in comparison with non-euro area countries with similar
attributes. For example, Gibson et al. (2012: 515) find that the case of
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Greece ‘strongly support[s] the view that the low levels of interest-rate
spreads reached in the mid-2000s were not justified by the economic
fundamentals’. From Figures 1 3 below, we can clearly observe that
there was almost no difference in euro area sovereign bond yields before
the crisis. In fact, the difference in yields on the sovereign bonds of
periphery countries and those of core countries, led by Germany, was
less than 40 basis points.7 Pagano and von Thadden (2004: 552) conclude
that during the pre-crisis period, ‘issuers and investors alike [came] to
regard the euro area bond market as a single one’. This is despite
‘substantial and lasting differences across countries in terms of inflation
and unit labour costs’ (European Commission, 2008: 63). While market
discipline was not completely lacking, it was inadequate during the pre-
crisis period. This market complacency allowed bond yields to remain
relatively low during the pre-crisis period despite diverging economic

Figure 1 Ten-year sovereign bond yields for ‘core’ eurozone countries.

Source: ECB (2014)

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 C HANG AND LEBLOND: A LL IN
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Figure 2 Ten-year sovereign bond yields for ‘periphery’ eurozone countries ‘with
low private debt’.
Source: ECB (2014)

performances. Market expectations of the euro area’s integrity allowed

countries like Greece to be judged on the basis of their participation in the
presumably inviolable eurozone rather than on their domestic economic
conditions and policies. This changed after the global financial crisis.

Figure 3 Ten-year sovereign bond yields for ‘periphery’ eurozone countries ‘with
high private debt’.
Source: ECB (2014)

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

Crisis-period bond market behaviour

Yield spreads on euro area sovereign bonds started to disperse in the
summer of 2008 (see Figures 1 3) because of increased global aversion to
risk in financial markets after the subprime mortgage crisis in the United
States (Barrios et al., 2009; Bernoth and Erdogan, 2012; von Hagen et al.,
2011). For instance, Germany had become a safe haven for investors,
driving down German bond yields (von Hagen et al., 2011). Then, in early
2010, yields on 10-year Greek government bonds began to rapidly
increase to what would become fiscally unsustainable levels. The Greek
crisis spread to other euro area member states, serving as a ‘wake-up call’
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to investors who had previously ‘largely ignored macroeconomic

indicators’ (Giordano et al., 2013: 18). Irish and Portuguese bond yields
began to rise soon thereafter, ultimately reaching levels that forced their
governments to accept bailouts in November 2010 and April 2011,
respectively. One year or so after the beginning of the Greek debt crisis,
Cypriot, Italian, Slovenian and Spanish bond rates began to edge signifi-
cantly upwards, eventually reaching rates that were close to unsustain-
able (see Figures 2 and 3).8 Other euro area member states’ bond yields
remained for the most part comfortably below 5 percent and tracked
German rates, albeit at a distance (see Figure 1). Finally, starting in
August 2011 with Ireland and gradually followed by others, sovereign
bond yields began to ease downward (see Figures 1 3). By the second
half of 2012, bond investors clearly thought that the worst was over. By
the spring of 2014, except for Cyprus and Greece, eurozone sovereign
bond yields were back at levels at or below their pre-crisis levels.

THE ARGUMENT: FEAR FOR THE EUROZONE’S

INTEGRITY
A preliminary understanding of the eurozone sovereign debt crisis can
be derived from theories originally used to explain currency crises. The
first wave of the currency crisis literature focused on economic funda-
mentals as the source of crises. A crisis would occur when investors
would begin selling off assets denominated in a given currency because
macroeconomic fundamentals indicated that the country’s official foreign
exchange reserves were declining (i.e., the balance of payment was in
deficit), which would force a devaluation of the currency (Bordo and
Schwartz, 1996; Goldstein et al., 2000; Krugman, 1979). A debate arose,
however, in which economists argued over whether more than one
exchange rate equilibrium was possible for a given set of economic condi-
tions. Thus, a second wave of explanations posited that market expecta-
tions needed to be factored in (Obstfeld, 1986, 1996): i.e., a currency crisis
would occur if investors believed that the government was unwilling or

8
 C HANG AND LEBLOND: A LL IN

unable to defend the currency. Markets therefore evaluated both eco-

nomic and political conditions.9 As Chang (2004: 3, emphasis in original)
argues, ‘this idea of a self-fulfilling speculative attack implies that market
expectations may be at least as important in explaining currency crises as
economic fundamentals. Government credibility becomes critical, and this
necessarily hinges on politics’.
A similar debate has emerged in the context of the euro area sovereign
debt crisis, with economists arguing for the presence (or absence) of self-
fulfilling speculative attacks in bond markets that appear at odds with
actual debt and deficit levels. De Grauwe and Ji (2012, 2013) compared
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the fiscal conditions of countries within the euro area with those located
outside, concluding that there was a shift in market sentiment that drove
a country from a ‘good’ (optimistic) equilibrium, where debt financing is
cheap and supports growth, to a ‘bad’ (pessimistic) equilibrium, where
debt financing is expensive and growth is negative with strong pressures
for fiscal austerity:10 ‘When fear and panic take over, sales of government
bonds become massive, creating increases in the interest rate (and the
spreads) on government bonds in the absence of observable changes in
the fundamentals’ (De Grauwe and Ji, 2012: 878).
The above argument is premised on the idea that euro area govern-
ments face the same ‘sudden stop’ risk as do emerging countries that bor-
row from international investors in a foreign currency (Mosley, 2004:
182). By adopting the euro, governments can no longer monetize their
debt as they have given up control over monetary policy, which is now
in the hands of the strongly independent European Central Bank (ECB).
As such, eurozone governments cannot ensure that they will always
have money to pay back bondholders (De Grauwe and Ji, 2013). As Gros
(2011: 2) explains: ‘Countries that have their own currency and issue debt
in that currency never have to outright default. If push comes to shove,
they can always use the printing press to pay off the debt’.
But why did market sentiment change in the euro area? Other authors
have attempted to explain what triggered the eurozone’s sovereign debt
crisis. In the case of Greece, for example, the following explanations have
been offered: (1) the delay of or insufficient funding of the bailouts
(Ghosh et al., 2013); (2) a continued lack of fiscal discipline and structural
reforms in spite of the adjustment program associated with the bailout
(Gibson et al., 2012); (3) concern over a potential breakup of the euro area,
rooted in the belief that Greece no longer participated in a ‘regime of fully
credible EMU commitments under guaranteed fiscal liabilities’
(Arghyrou and Kontonikas, 2011: 11) after a series of ‘public disagree-
ments and careless statements at critical junctures’ had eroded investors’
confidence (Carmassi and Micossi, 2010).
How can we distinguish between these three possible motivations? If
the concern were linked to bailouts, we would expect a bailout

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announcement to ease market tensions. Therefore, bond yields should

have plummeted after the May 2010 rescue package was announced;
instead, yields on Greek debt continued to rise.11 Indeed, bailouts could
exacerbate market tensions by making official debt senior to private debt,
thereby reducing the chances of private bondholders being repaid. The
second explanation focuses on the willingness of a government to under-
take an internal devaluation, specifically implementing reforms that
would restore the economy’s competitiveness and the government’s pub-
lic finances while remaining in the monetary union.12 Therefore, one
would expect rising bond yields to correlate with signs that such an inter-
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nal devaluation was taking place and making default less likely. While
the revelation of the false data reported by the previous Greek govern-
ment incited the initial market jitters, neither its economic nor its policy
trajectory since then can explain the patterns of its fluctuations in bond
yields. The third explanation posits a potential breakup of the eurozone,
which corresponds to some countries abandoning the euro and reintro-
ducing the national currency at a much-devalued exchange rate. While
this could restore international competitiveness, the country in question
would likely default on much of the debt in euros held by foreign
investors.13
Thus, international sovereign bond investors in the euro area face three
possible scenarios when a member state’s public finances are on an
unsustainable path: (1) the member state’s debt is guaranteed by the rest
of the eurozone (and the International Monetary Fund [IMF]), regardless
of its level; (2) the member state’s government(s) will undertake the nec-
essary fiscal and economic reforms, possibly with temporary external
financial assistance, in order to make its public finances sustainable and
remain in the eurozone; (3) the member state will leave the euro area,
reintroduce the national currency and default on its sovereign debt.
As long as sovereign bond investors believe in Scenario 1 or 2, then
they have no reason to panic and cause a debt crisis by asking for unsus-
tainable interest rates. Even though these two solutions include the possi-
bility of a partial default, historically, some restructuring has always been
necessary to alleviate large debt burdens (Reinhart and Rogoff, 2013).
Within the relatively controlled context of euro area membership,
defaults would likely be partial and accompanied by additional measures
to restore credibility. In addition, euro area membership gives countries
access to emergency funding.
The prospect of the third scenario implies serious potential losses for
bond investors (and the country’s population), as the exiting member
state would suffer grave economic consequences and, consequently,
would be unable to sustain its public debt. Numerous studies have been
published outlining the negative ramifications of the exit of a peripheral
country from the euro area: declining cross-border capital flows, the

10
 C HANG AND LEBLOND: A LL IN

External
financial
assistance
available
(%)
Scenario 1
100

Scenario 2
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Scenario 3

0
1 Probability
of default

Figure 4 Illustration of investor expectations for the euro area (yields on sover-
eign debt increase as expectations move down the scenario curve).

reimposition of capital controls, technical and legal issues over the

denomination of debt, inflation, bank runs, the imposition of tariffs on
former members to adjust for any exchange rate benefits from reintroduc-
ing a weaker currency, and the loss of access to the eurozone’s system of
interbank payments (Aslund, 2012; Belke, 2011; Buiter, 2011; Eichen-
green, 2007). Given that an exit from the euro area would likely be accom-
panied by an exit from the EU, the exiting country would also lose access
to the internal market as well as any source of EU funding. Thus, faced
with the possibility of such a scary scenario, sovereign bond investors
will demand higher yields to compensate the increased risk of experienc-
ing losses.
The three scenarios described above are part of a continuum, as illus-
trated by Figure 4 above, where there is an inverse relationship between
the (expected) availability of financial assistance (amount and duration)
and the probability of default (assessed by investors). Below a certain
level of external financial assistance, the probability of leaving the euro-
zone and defaulting on the sovereign debt (i.e., Scenario 3) increases rap-
idly. This is because the insufficient external financial assistance makes
the necessary internal devaluation (fiscal consolidation and structural

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

reforms to the economy, i.e., austerity) so politically unpalatable that a

member state government deems it more acceptable to abandon the euro
and default on the debt. The key hypothesis arising from this analytical
framework is that as investors’ expectations move down along the sce-
nario curve, depending on economic fundamentals and the credibility of
external financial commitments, the bond yields that they require to
finance government debt increase accordingly, reaching a ‘sudden stop’
level when Scenario 3 gets close to 1 on the horizontal axis.
It is important to note that Scenario 3 is likely to be contagious from
investors’ perspective: if one troubled member state is facing insufficient
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external financial assistance, then it is probable that other member states

that could eventually be in a similar situation will also not receive
enough financial assistance. It is in such a context that sovereign bond
investors come to fear for the eurozone’s integrity, since it means heavy
losses for them. Solidarity, in terms of financial assistance, among euro
area member states and institutions is thus key to maintain or restore
investors’ confidence. That way, bond yields can remain or become rela-
tively low such that a crisis is averted or resolved. The idea is to negate
the self-fulfilling nature of financial crises caused by investors’ expecta-
tions of a euro area breakup.

EXPLAINING SOVEREIGN BOND INVESTORS’

BEHAVIOUR IN THE EURO AREA
Investors’ expectations with respect to euro area member states’ public
finances have moved down and up the scenario curve illustrated in
Figure 4 as the crisis has ebbed and flowed between 2009 and 2014. This
section applies the analytical framework to the euro area crisis and dem-
onstrates its empirical validity.
In the years prior to the crisis, yields on euro area sovereign bonds
were nearly all equivalent to each other, with yield spreads between the
German bonds (the base reference) and other euro government bonds
being around 20 basis points on average, with a very small standard
deviation (Leblond, 2006: 980 981). According to our framework, this
means that investors viewed all euro area member states in the upper
part of the Scenario-2 segment of the scenario curve in Figure 4. Thus,
they believed that if a member state experienced fiscal pressures that
threatened the sustainability of its public finances, (1) it would undertake
the necessary measures to redress the situation and, if necessary, (2) it
would receive financial assistance from the EU/eurozone to ease this
adjustment.
Why did sovereign bond investors believe this? The credibility of the
no-bailout prohibitions in the Maastricht Treaty was questioned right
from the beginning of the EMU project (e.g., Alexander and Anker, 1997;

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 C HANG AND LEBLOND: A LL IN

Deutsche Bank Research, 2001; Jahjah, 2001). This is why the SGP was
considered necessary for the monetary union’s proper functioning.14
Arghyrou and Tsoukalas (2011: 181) claim that ‘markets had never
believed the no-bailout clause and had been pricing, even well into the
crisis, Greek and other EMU bonds assuming a bailout’ (see also Mosley,
2004: 198). In other words, debt sustainability is in the eye of the
beholder: as long as investors believed in the solidarity or integrity of the
euro area, bond yields remained reasonable.
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Starting points and fiscal behaviour during the crisis

The literature on financial crises usually identifies two types of public
debt crises. The first one involves high government spending and insuffi-
cient fiscal revenues due to the economy’s weak competitiveness. Fiscal
deficits become increasingly unsustainable as public debt mounts (e.g.,
Greece). The crisis begins when bond investors start asking for higher
yields to cover the increasing risk of debt default, until they just stop
financing the government’s deficits and debt altogether. The second type
of debt crisis is the one caused by a banking crisis, where the government
has to bail out the failing banks in order to prevent the economy’s com-
plete collapse. This is what happened in Ireland. The problem here is not
that the economy is uncompetitive or that the government is spending
too much, it is that it cannot afford to bail out its banking system. Again,
investors become less inclined to buy the government’s bonds, whose
proceeds are being used to recapitalise the banks, because they increas-
ingly fear that the government may not have the means to pay back its
debt in full.
Given the existence of two ‘ideal’ types of debt crises, we have mapped
eurozone member states according to their economy’s competitiveness
and their level of private domestic indebtedness on the eve of the euro
area fiscal crisis erupting in the fall of 2009 (see Figure 5). We can observe
that there were three broad types of eurozone countries. The first group
in Figure 5 contains what we call the ‘core countries’, which have rela-
tively higher competitiveness levels and low private domestic indebted-
ness: Austria, Belgium, Finland, France, Germany and the Netherlands.15
In addition, their public finances were in order (see Table 1). These are
the countries that were of no concern to investors, as Figure 1 makes
clear.
The second group is made up of periphery countries with low levels
of competitiveness but also low levels of private debt in the domestic
economy: Greece, Italy, Malta and Slovenia. Only Greece suffered an
actual debt crisis, as per Figure 2, because its public finances were on
an unsustainable path (see Table 1). According to Figure 2, Italy and

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY
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Figure 5 The economic situation of eurozone countries at the beginning of the cri-
sis. GDP, gross domestic product,  2008 2009,  2008 (end of year).
Sources: World Economic Forum (2008: 10) and IMF (2014).

Slovenia suffered some contagion from the eurozone crisis in 2011 and
2012 but were able to keep bond yields from moving above 7 percent,
which is often considered a threshold for making debt financing unsus-
tainable. They were able to do so by keeping government spending in
check, thereby maintaining control over fiscal deficits (see Table 1).16
The third and final group found in Figure 5 is composed of periphery
countries with high levels of private debt in the domestic economy:
Cyprus, Ireland, Portugal and Spain. These are countries that all experi-
enced banking crises of varying intensities due to inflated real estate mar-
kets, and required external financial assistance to help them pay for their
failing banks and quickly mounting public debts (see Table 1) as crisis
contagion spread through the eurozone (see Figure 3).17
Deteriorating economic conditions alone do not explain bond yield
movements. Investors gauge the likelihood that they will be repaid,
which is contingent on both domestic politics and European politics. In
particular, the increasing likelihood that the euro area would disintegrate
exacerbated problems; conversely, confidence in the euro area’s stability
eased market pressure substantially. Markets not only looked at short-
term considerations that could be resolved by the promise of a bailout,
they were also concerned with the longer-term integrity of the euro area.
Let’s now analyse some of these problematic cases in more detail in order
to understand how well they fit the argument developed in the previous
section.

14
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Table 1 Fiscal balances and public debts in eurozone countries.

Fiscal balances (% of GDP) Public debts (% of GDP)

2006 2007 2008 2009 2010 2011 2012 2013 2006 2007 2008 2009 2010 2011 2012 2013

Core countries
Austria ¡1.5 ¡0.9 ¡0.9 ¡4.1 ¡4.5 ¡2.5 ¡2.6 ¡1.5 62 60 64 69 72 73 74 74
Belgium 0.4 ¡0.1 ¡1.0 ¡5.6 ¡3.8 ¡3.8 ¡4.1 ¡2.6 88 84 89 97 97 99 101 101
Finland 4.2 5.3 4.4 ¡2.5 ¡2.5 ¡0.7 ¡1.8 ¡2.1 40 35 34 44 49 49 54 57
France ¡2.3 ¡2.7 ¡3.3 ¡7.5 ¡7.0 ¡5.2 ¡4.9 ¡4.3 64 64 68 79 83 86 91 94
Germany ¡1.6 0.2 ¡0.1 ¡3.1 ¡4.2 ¡0.8 0.1 0.0 68 65 67 75 82 80 81 78
Netherlands 0.5 0.2 0.5 ¡5.6 ¡5.1 ¡4.3 ¡4.1 ¡2.5 47 45 58 61 63 66 71 74
Periphery countries with low private debt

15
Greece ¡5.7 ¡6.5 ¡9.8 ¡15.7 ¡10.9 ¡9.6 ¡8.9 ¡12.7 106 107 113 130 148 170 157 175
Italy ¡3.4 ¡1.6 ¡2.7 ¡5.5 ¡4.5 ¡3.7 ¡3.0 ¡3.0 106 103 106 116 119 121 127 133
Malta ¡2.7 ¡2.3 ¡4.6 ¡3.7 ¡3.5 ¡2.7 ¡3.3 ¡2.8 62 61 61 66 66 69 71 73
Slovenia ¡1.4 0.0 ¡1.9 ¡6.3 ¡5.9 ¡6.4 ¡4.0 ¡14.7 26 23 22 35 39 47 54 72
Periphery countries with high private debt
Cyprus ¡1.2 3.5 0.9 ¡6.1 ¡5.3 ¡6.3 ¡6.4 ¡5.4 65 59 49 58 61 72 87 112
C HANG AND LEBLOND: A LL IN

Ireland 2.9 0.2 ¡7.4 ¡13.7 ¡30.6 ¡13.1 ¡8.2 ¡7.2 25 25 44 64 91 104 117 124
Portugal ¡4.6 ¡3.1 ¡3.6 ¡10.2 ¡9.8 ¡4.3 ¡6.4 ¡4.9 69 68 72 84 94 108 124 129
Spain 2.4 2.0 ¡4.5 ¡11.1 ¡9.6 ¡9.6 ¡10.6 ¡7.1 40 36 40 54 62 71 86 94
GDP, gross domestic product. Source: Eurostat (accessed 12 June 2014)
 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

Greece
The eurozone financial crisis began in earnest in November 2009, when
yields on Greek sovereign bonds took off. According to Arghyrou and
Tsoukalas (2011), investors reacted negatively to the budget submitted to
the European Commission in mid-November 2009. The authors claim
that the budget insufficiently addressed Greece’s growing fiscal deficit,18
which the newly-elected Panhellenic Socialist Movement (PASOK) had
indicated would be 12.8 percent of GDP in 2009 rather than 3.6 percent,
as originally forecast by the previous government (Featherstone, 2011:
199).19 Although the new government of George Papandreou committed
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itself to reducing the deficit to 9 percent of GDP in 2010, credit-rating

agencies and sovereign bond investors deemed the effort inadequate (The
Economist, 19 December 2009, 89 [US edition]).20 Confidence was also
undermined by the official confirmation of a ‘lack of quality of the Greek
fiscal statistics’ by the European Commission in January 2010, formally
acknowledging that Greece had submitted poor data for years, blaming
not only ‘methodological weaknesses and unsatisfactory technical
procedures’ but also a system prone to ‘political pressures and electoral
cycles’ (European Commission, 2010: 4).
As early as February 2010, euro area governments agreed in principle to
come to Greece’s rescue. Verbal promises were ultimately not enough to
calm sovereign bond investors,21 especially after Greece’s fiscal deficit for
2009 was again announced to be higher than previously thought: 13.6 per-
cent rather than the 12.7 percent estimated in December.22 In April, euro-
zone member states committed €30 billion to help Greece’s government
pay back debt that was maturing over the next year in exchange for bud-
getary cutbacks. The IMF contributed an additional €10 15 billion to this
package, for a total emergency loan facility of €40 45 billion. Market ten-
sions increased due to uncertainty in finalizing the details of Greece’s res-
cue package and to another downgrading (by three notches, from BBBC
to BBC [junk status]) of Greek sovereign debt by Standard and Poor’s
(S&P).23 Therefore, eurozone members and the IMF increased their emer-
gency loan facility to €110 billion on 3 May 2010, with the eurozone put-
ting €80 billion on the table while the IMF was in for €30 billion.24 This
amount represented about one third of Greece’s total outstanding sover-
eign debt at the end of 2009 and was originally set to last three years.25
Surprisingly, at least according to our analytical framework, sovereign
bond investors did not calm down: they considered Greek sovereign
debt riskier and riskier until 10-year bond yields reached a high of
around 30 percent in February 2012. So, instead of moving up the curve
in Figure 4 into Scenario 2, investors moved down the curve as they
increasingly expected Scenario 3 (the so-called ‘Grexit’) to become reality.
The reason is they considered the bailout insufficient to solve Greece’s

16
 C HANG AND LEBLOND: A LL IN

fiscal problems. Kirkegaard (2010a) captured investors’ mood in his com-

ments on the bailout package:

[T]he assumption is that Greece will be able to pay it all back. How-
ever, that is far from guaranteed. Even if the plan succeeds, Greece
will have a debt-to-GDP ratio of at least 150 percent by 2012 and
only marginally improved medium term growth prospects. Will
financial markets lend to Greece burdened by such debts at 5 per-
cent for 10 years, even after it undertakes structural reforms?
Almost certainly not! In short, even a successful joint Europe/IMF/
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Greek government aid program only postpones an inevitable Greek

debt restructuring by a few years at the cost of €120 billion to
eurozone taxpayers.26

Belke (2013) added that the likelihood of bond investors being repaid
conceivably worsened with the bailout in that official creditors received
seniority over private debt. This pessimistic view was reinforced by sev-
eral credit rating downgrades by S&P, Moody’s and Fitch between June
2010 and July 2011: BBC to CC, A3 to Ca, and BBB- to CCC, respectively.
After months of political wrangling, Greece’s sovereign debt was
restructured at the end of October 2011: investors agreed ‘voluntarily’ to
the equivalent of a 50 percent discount on their holdings of Greek debt
by exchanging their existing bonds against new bonds with longer
maturities and lower interest rates (‘private sector involvement or PSI’).
This agreement was accompanied by additional financial assistance from
Greece’s eurozone partners and the IMF.27
Markets initially reacted positively to news of this deal, though signifi-
cant scepticism remained as to whether additional restructuring would
be needed in the future given the political difficulties faced by Greek gov-
ernments in implementing reforms to make the economy more produc-
tive and public finances more sustainable (Moody’s, 2011). However,
panic quickly set in again amongst investors on 31 October when Greek
Prime Minister George Papandreou unexpectedly announced that he
would submit the new financial assistance package to a referendum. He
quickly retracted this idea amidst the political and economic upheaval
that ensued inside and outside Greece. Papandreou resigned in Novem-
ber 2011, and the Greek president called for new elections in May 2012.
In early 2012 a second Greek bailout was negotiated, with yields falling
across the eurozone periphery as ‘a disorderly default was avoided’
(Financial Times, 21 February 2012), with an additional €164.5 billion
from the European Financial Stability Fund (EFSF) and the IMF plus
more PSI. Yields had reached a 30.5 percent high in March 2012 when
‘fears over a Greek exit from the Eurozone reached fever pitch’ (Financial
Times, 15 October 2013). Although yields had decreased significantly in

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

March 2012, they began rising again in April 2012. It was only after June
2012 that yields on Greek bonds began their secular downward trajec-
tory, with significant decreases in the fall of 2012.
What accounts for falling bond yields? First, the domestic political
front had stabilized, making the necessary reforms (including but not
limited to fiscal consolidation) more likely. Greece had a newly elected,
relatively stable coalition government in place under the prime minister-
ship of Antonis Samaras, who was committed to the ongoing adjustment
programmes under the various bailout packages but with relaxed dead-
lines to meet its economic targets. The Samaras government’s commit-
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ment to fiscal consolidation was underscored with an apparently tough

2013 budget passed in November 2012.28
Second, Greek debt levels became more manageable. The government
had reached an agreement with the Troika to rewrite the terms of the sec-
ond rescue package agreed to a year earlier: a reduction in interest rates
and fees on existing loans, an extension of loan maturities, a 10-year
deferral on interest payments on loans from the EFSF and receipt of any
profits made by the ECB on its holdings of Greek debt. Moody’s (2012a:
2) concluded that the ‘new terms [were] effectively a form of debt for-
giveness. . . [and] would help avoid a near-term second default on Greek
government debt, and increase in the probability that Greece will remain
part of the euro area’. With a December 2012 debt buyback at an average
market value of 34 cents in the euro, the above measures were expected
to bring down Greek sovereign debt to a manageable, yet still risky,
120 130 percent of GDP by 2020.
Third, this period coincided with ECB president Mario Draghi’s late
July 2012 announcement that the ECB was ‘ready to do whatever it takes
to preserve the euro’ (see below for details), which only reinforced the
notion that a Grexit no longer represented a viable threat. This explains
why 10-year bond yields on Greek debt dropped from an average of 28
percent in June 2012 to an average of 6.2 percent for the month of April
2014. Thus, in terms of Figure 4 above, investors’ expectations had moved
up the curve from far on Scenario 3 to the lower end of Scenario 2 now
that it was clear that Greece would stay firmly inside the euro area with
the help of its eurozone partners, the ECB and the IMF. And with contin-
ued euro area membership came the assurance of financial assistance
and continued pressure to make economic reforms, making the euro
area’s integrity an indispensable component of a virtuous circle that ulti-
mately results in the repayment of debt.

Contagion and crisis

Of the periphery countries with high levels of private indebtedness in
the domestic economy, Ireland was the first to officially request financial

18
 C HANG AND LEBLOND: A LL IN

assistance from the EU and the IMF (on 21 November 2010). The bailout
package totalled €85 billion: €45 billion from the EU (half from the Euro-
pean Commission and the other from the EFSF), €22.5 billion from the
IMF and the €17.5 billion from Ireland itself (by using cash reserves and
the National Pension Reserve Fund). As in the Greek case, bond yields
on Irish sovereign debt continued their upward trend for many months
after the bailout (see Figure 3). First, the bailout amount was generally
considered too expensive for Ireland, especially since the Irish govern-
ment had to plunder its public pension system to contribute to it, and
insufficient to cover the extent of Irish banks’ losses. Second, Ireland had
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to have a general election before mid-July 2012, and the likely loss of the
governing Fianna F ail cast a shadow on the bailout package’s implemen-
tation (Kirkegaard, 2010c). After a period of political turmoil, a new coa-
lition government (Fine Gael and Labour) was elected at the end of
February 2012. This new government proved effective at implementing
the measures agreed upon with the Troika under the bailout arrange-
ment, to the point where it was expected that the Irish economy would
grow in 2011 and the fiscal deficit would be below its target (in part
because the cost of recapitalizing the banks was less than anticipated)
(European Commission, 2011). Moreover, in conjunction with a second
financial assistance package for Greece proposed at the end of July 2011,
Ireland effectively saw the interest rates charged on its loans from the
EFSM and EFSF lowered. Thus, longer-term concerns over the imple-
mentation of the bailout package as well as the integrity of the euro
(indicated by the new Greek package) had shifted. As a result, bond
yields on Irish debt began to decline steadily in August 2011. In terms of
Figure 4, this means that investors gradually pushed Ireland up the
expectation curve, from Scenario 3 to well within Scenario 2 by the end
of 2012.
In early April 2011, Portugal was the third eurozone member state to
request financial assistance from the EU and the IMF, and the second to
benefit from the EFSM and EFSF. The request came on the heels of the
fall of the S
ocrates government and credit ratings downgrades by Stan-
dard & Poor’s and Fitch of Portugal’s main banks as well as its sovereign
debt, to one level above junk status.29 Thus, at the beginning of May
2011, the EU and the IMF agreed to grant Portugal a total of €78 billion in
financial assistance, of which €12 billion was earmarked for aiding the
banking sector. Again, despite the bailout, Portuguese bond yields con-
tinued to rise until the spring of 2012. One reason is that it remained to
be seen whether the newly elected centre-right government of Pedro Pas-
sos Coelho (in early June 2011) would be able to meet the economic tar-
gets specified in the bailout agreement, though it had made clear to
voters its commitment to the reforms during the campaign and received
a strong popular mandate.

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

Another reason is the political uncertainty surrounding Greece’s debt

restructuring in the summer and fall of 2011: ‘We believe that in the event
Greece does not reach an agreement with its creditors and enters into a
disorderly default instead, the contagion effect on Portugal will certainly
be to deteriorate that country’s expected default [assessment] even fur-
ther’ (Moody’s, 2012b: 3).
With the effective orderly restructuring of Greece’s debt in March 2012
and the positive assessment given by the Troika to the Portuguese gov-
ernment on meeting its bailout programme targets at the end of February
(IMF, 2012), bond investors became more confident that Portugal would
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avoid a messy default and exit from the eurozone. Thus, expectations for
Portugal began moving back to Scenario 2 as investors gained confidence
in the Portuguese government’s ability to pay back its debt. Again, this
confidence was underpinned by a strong belief in the euro area’s
integrity.
Like Ireland and to a somewhat lesser extent Portugal, Spain suffered
a major banking crisis that more than doubled the government’s debt as
a percentage to GDP in only a few years (see Table 1). However, unlike
its banking crisis brethren, the largest Spanish banks were not the ones
experiencing troubles: it was the regional savings banks, the cajas, that
were exposed to the bursting of the country’s real estate bubble (Quaglia
and Royo, 2014). In the wake of the Irish bailout, yields on Spanish sover-
eign bonds began to rise in November 2010 (see Figure 3). After several
failed attempts to reform the regional banking sector, the Spanish gov-
ernment finally accepted, in June 2012, a rescue package from the EU in
the amount of 100 billion euros in order to recapitalize the banking sector
and relieve pressure on the government’s finances (see Quaglia and
Royo, 2014).
However, it was not until the ECB restated its resolve at the end of July
2012 to do whatever its takes to preserve the euro and the eurozone that
Spanish bond yields effectively began declining, in August 2012 (see
Figure 3). Given that Italy’s bond yields followed a trajectory very similar
to those of the Spanish government (see Figure 3), it seems fair to con-
clude that, ultimately, only the ECB’s unlimited firepower could satisfy
investors that major countries such as Italy and Spain would remain
inside the eurozone and thus firmly within Scenario 2. It had been clear
from the beginning that the EU did not have the means to bail out Spain
and/or Italy in the same way that it did Greece, Ireland and Portugal.
Draghi’s promise and the positive implications for the eurozone’s integ-
rity alleviated market fears despite widespread acknowledgement that a
Spanish (or Italian) bailout would be too expensive for the euro area.
Despite the different origins of the Greek, Irish, Portuguese and Span-
ish crises (see Figure 5), they share their vulnerability owing to the conta-
gion that arose as a result of investors questioning the euro area’s

20
 C HANG AND LEBLOND: A LL IN

integrity. While economic fundamentals and the degree of political diffi-

culties in implementing reforms varied, the key factor in calming down
market expectations rested with the assurance of the euro area’s integrity.

Institutional mechanisms and actions to help resolve the

eurozone debt crisis
In addition to the above-mentioned events and actions pertaining to indi-
vidual eurozone member states, institutional developments at the supra-
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national level contributed to shifting investor perceptions and easing

bond market pressures, though it has to be mentioned that it was the
ECB’s actions that were most effective. This can be attributed not only to
the resources of the ECB but also to the fact that its actions were not met
with the conflicting messages that came from other institutions. Specifi-
cally, in the Council member states disagreements often overshadowed
the compromises that were ultimately found. Thus, ECB actions instilled
greater confidence in the euro area’s integrity.
In May 2010, the EU devised an important rescue mechanism worth
750 billion euros, whose main feature was the EFSF (see note 25 for
details). It did not take long, however, for investors to recognize that the
EFSF’s temporary nature (scheduled to end in June 2013) was going to be
a problem, since it was by then almost certain that fiscal strains in the
eurozone would last well beyond 2013. Consequently, the EU leadership
agreed at its European Council meeting in December 2010 to turn the
EFSF into a permanent EU institutional feature: the European Stability
Mechanism (ESM). Unfortunately, this new measure had no immediate
effect on the bond yields affected by the crisis. The general consensus
was that it remained insufficient to deal with the potential bailout needs
of the larger European economies, such as Italy and Spain, as mentioned
above (Gros and Giovannini, 2011; Leblond and Paudyn, 2011). As such,
investors did not consider the ESM sufficient to bring all eurozone mem-
ber states safely within Scenario 2 in Figure 4 above and remove invest-
ors’ fears that the euro area’s integrity was at risk.
It was the ECB that was particularly effective in ensuring the euro’s
integrity. In December 2011, the ECB started its long-term refinancing
operations (LTROs) that provided cheap liquidity to banks, thus taking
another step towards acting as the lender of last resort for the euro area
(Buiter and Rahbari, 2012). ECB President Mario Draghi had tied the
ECB’s action to the ability of member state governments to form the fiscal
compact, which became the Treaty on Stability, Coordination and Gover-
nance. The short-term impact was positive; as Watkins (2012) noted,
‘Yields at Spanish and Italian government bond auctions [that] week
were sharply lower than in comparable previous sales’, but it was ‘no

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 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

silver bullet’ and the market uplift was fragile. A euro area breakup was
still the subject of speculation in early 2012. One study found a significant
correlation between the volume of searches using ‘euro break-up’ in Goo-
gle and the Italian interest rate differentials against Germany that are
unexplained by macroeconomic and financial models (Di Cesare et al.,
2012).
In the summer of 2012, under the threat of the escalating crisis in Spain,
the European Council, eurozone leaders and the ECB took decisive steps
to ensure the integrity of the euro’s membership by strengthening its
institutional framework (particularly financial integration) and creating a
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credible financial backstop that would obviate the need for a country to
default on its debt. On 26 June, the European Council outlined its vision
of moving Europe ‘towards a genuine economic and monetary union’
through integrated financial, budgetary and economic policy frameworks
while ensuring democratic accountability (Van Rompuy, 2012). This was
followed a few days later by the euro area summit that noted, ‘It is imper-
ative to break the vicious circle between banks and sovereigns’ (Euro-
pean Council, 2012), setting the stage for banking union.30
Finally, the biggest ‘game-changer’ of the crisis was ECB president
Mario Draghi’s promise in July 2012 to do ‘whatever it takes to preserve
the euro’. This resulted in the ‘outright monetary transactions’ (OMT) in
which the ECB promised to intervene in unlimited amounts for countries
under an ESM programme. Despite criticisms and legal challenges (par-
ticularly from Germany), Draghi praised OMT as ‘probably the most suc-
cessful monetary policy measure undertaken in recent times’ (Steen,
2013). With OMT, the eurozone sovereign debt crisis abated. This com-
mitment to unlimited financial assistance finally convinced sovereign
bond investors that the euro area’s integrity was assured. Scenario 3 in
Figure 4 was no longer an option for any eurozone member states.

CONCLUSION
While the sovereign debt crisis generally confirms the importance of debt
sustainability to bond yields, it also highlights the vagaries of market sen-
timent, echoing behaviour in currency markets. Investors underpriced
risk prior to the crisis. Afterwards, their assessments of euro area coun-
tries were inconsistent and could not be traced solely to respective fiscal
deficits, debt levels and economic competitiveness.
As in the currency crises of the 1980s and 1990s, market expectations
during the eurozone crisis were only partially based on economic funda-
mentals. In fact, expectations were largely self-fulfilling and depended
less on fiscal policy reform and more on the likelihood of a euro area
breakup, which itself was more a function of the external financial assis-
tance that was on offer. Policies and mechanisms that increased financial

22
 C HANG AND LEBLOND: A LL IN

support to member states in trouble were stronger indicators of the euro

area remaining intact (as per Scenarios 1 and 2 in Figure 4). The bailout
funds were, however, too short-term and the funding too limited to have
much of an impact on market expectations. Support mechanisms with
larger amounts of potential funding like the LTROs and OMT were more
successful at bringing countries back up towards Scenario 2. They were
also more indicative of the ultimate solidarity of the eurozone, as the too-
small bailouts sometimes worsened market fears by highlighting the ris-
ing reluctance of the euro area to continue rescuing its fellow member
states. This gave rise to speculation about a euro area breakup that only
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the OMT announcement ended up abating for good.

The analysis presented herein points to the key role played by external
financial assistance to individual member states and the resulting signs
of the enduring nature of EMU. The ECB was critical to managing market
expectations, as it is the only institution with unlimited financial fire-
power. It also had to be unequivocal in its support. The institutional com-
mitment to greater centralization of authority via a banking union also
provided more reassurance than did further coordination in fiscal policy.
This suggests the need for greater integration (as opposed to coordina-
tion of national policies). Moreover, our analysis suggests that all of the
emphasis placed on austerity and fiscal policy coordination may have
been a diversion. Although fiscal sustainability is important to the long-
term health of euro area economies, it seemingly does little to quell mar-
ket fears in the short term. More focus on ensuring the long-term viability
of the eurozone itself does much more to renew market confidence and
prevent self-fulfilling speculative attacks.

ACKNOWLEDGEMENTS
We would like to thank David Howarth and Lucia Quaglia for having
made this paper possible. We are also very grateful for the excellent com-
ments received from two anonymous reviewers. They really helped
sharpen our thinking.

NOTES
1. At the time of writing (June 2014), there were still doubts as to whether the
crisis was over; however, the continued decline in bond yields in 2013 and
2014, the return of economic growth in the euro area, albeit at very modest
levels, and the end of the official bailout programmes in Ireland and Portugal
strongly suggest that the crisis has passed. Unfortunately, this does not mean
that the difficult task of reforming public finances and the economy is now
behind eurozone governments and people.
2. It is important to note that there exists a substantial body of literature that
argues that monetary integration would constrain government spending in

23
 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

the euro area (e.g. Bovenberg et al., 1991; Glick and Hutchison, 1993;
Mongelli, 1999).
3. These prohibitions are found in Articles 123 125 TFEU (Treaty on the Func-
tioning of the European Union) (Articles 101 103 of the Maastricht Treaty).
In a review of the literature on fiscal federalism, Oates (2005) casts doubts on
the effectiveness of such bailout prohibitions.
4. This decrease in bond yields is a result of the decrease in inflation and liquid-
ity risk, as well as the elimination of exchange risk, that were expected to
result when countries adopted the single currency.
5. There are other criteria for joining the single currency in the Maastricht
Treaty, as already mentioned, but the key criterion for deciding which coun-
tries would adopt the euro was the one on fiscal deficits (no more than 3 per-
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cent of GDP).
6. A similar situation prevailed in 1995 1997 with respect to emerging market
bonds, just before the East Asian financial crisis (Eichengreen and Mody,
1998).
7. One basis point equals one percent of one percentage point. For example, an
increase in the yield from 2.55 percent to 2.80 percent corresponds to an
increase of 25 basis points.
8. In Cyprus’s case, a bailout became necessary in the winter of 2013.
9. For an excellent study of the domestic politics that take place during currency
crises, see Walter and Willett (2012).
10. Aizenman et al. (2013), Arghyrou and Kontonikas (2011), Arghyrou and
Tsoukalas (2011), Ghosh et al. (2013), and Gibson et al. (2012) also subscribe to
this explanatory model of self-fulfilling multiple equilibria.
11. Irish and Portuguese sovereign bond yields also continued to increase after
the November 2010 and May 2011 bailouts, respectively.
12. The speed at which fiscal consolidation must be undertaken depends on the
extent and duration of financial assistance (i.e. bailouts) from external sour-
ces as long as international bond markets remain unwilling to finance the
government’s debt at reasonable interest rates. The availability of untapped
domestic savings to finance fiscal deficits will also make fiscal consolidation
easier.
13. For domestic bondholders, their euro-denominated debt gets converted to
the national currency so that it can be inflated away.
14. See Eichengreen and Wyplosz (1998) for an early sceptical view of the SGP’s
importance.
15. Luxembourg belongs in this group but data on banking claims are not
available.
16. The Slovenian government ran a large fiscal deficit in 2013; however, sover-
eign bond investors did not react negatively to this dismal fiscal
performance.
17. In Portugal’s case, the banking crisis was less intense but the government’s
public finances were much weaker than in the other three cases (see Table 1).
18. Gibson et al. (2012: 504) claim instead that it is the request by Dubai World for
a six-month debt moratorium that made bond investors more nervous. This
seems unlikely, however, since the spreads for the other GIIPS (Greece,
Ireland, Italy, Portugal and Spain) countries did not increase in November
2009.
19. According to Featherstone (2011: 199), the governor of the Bank of Greece
declared publicly only days after the election that the 2009 deficit was set to
be above 10 percent of GDP.

24
 C HANG AND LEBLOND: A LL IN

20. In December 2009, Fitch, another major credit-rating agency, downgraded

Greece’s debt to BBBC, which is two grades above junk status. It was the first
time in a decade that Greek sovereign ratings had fallen below the A grade.
A week later, Standard & Poor’s also lowered its rating of Greek sovereign
debt to BBBC. Finally, it was Moody’s turn a few days later to lower Greece’s
debt rating, from A2 to A1.
21. For a study of the effects of political communication on sovereign bond
spreads, see Gade et al. (2013).
22. The figure was again revised by Eurostat in November 2010, to 15.4 percent
of GDP. The final figure has been established at 15.7 percent of GDP (see
Table 1).
23. If a financial asset (e.g. a bond) is rated ‘junk’, then it means that certain
Downloaded by [College of Europe], [Michele Chang] at 07:52 21 August 2014

investors most especially conservative institutional investors like insur-

ance companies and pension funds can no longer buy such an asset. As a
result, there is less demand for this asset, which leads to a decrease in its
price and an increase in its yield.
24. The same day, not by coincidence, the ECB announced that it was suspend-
ing, in the case of Greek government debt, its requirement that debt instru-
ments accepted as collateral in refinancing operations satisfy a minimum
credit rating threshold. This measure ensured that eurozone banks would be
able to continue offering Greek sovereign debt as collateral against loans
from the Eurosystem even if credit ratings on Greek debt were falling below
the ECB’s minimal requirement. Nevertheless, such a decision was not with-
out controversy in terms of what it entailed for the ECB’s independence (see
Kirkegaard, 2010b).
25. A few days after the Greek bailout, on 9 May 2010, EU (not eurozone) gov-
ernments delivered a massive rescue package plan of €750 billion, because
they were afraid that the Greek crisis was becoming contagious, with Ireland
and Portugal increasingly at risk (see below for details). The sum was meant
to be at the disposal of any EU member state facing public finance difficulties.
It included €60 billion in balance-of-payment help from the European Com-
mission (European Financial Stability Mechanism [EFSM]), €440 billion in
eurozone-backed loan guarantees (European Financial Stability Fund [EFSF])
and, finally, €250 billion in loans from the IMF. All funds and guarantees
extended were subject to IMF conditionality rules. Furthermore, the ECB con-
tributed to this rescue operation by putting together a ‘securities markets
programme’ whereby it would purchase a limited number of government
bonds on financial markets in order to maintain (not increase) liquidity in
eurozone credit markets.
26. The use of the term ‘restructuring’ should not obscure the fact that it never-
theless amounts to a default, albeit an organized one.
27. The actual deal took place in March 2012.
28. The budget might have been considered tough, but in reality the fiscal deficit
was much higher in 2013 than in 2012 (see Table 1); however, sovereign bond
investors did not show that they were concerned with such a poor fiscal per-
formance (see Figure 2) given the external support and guarantees accorded
to the Greek government and economy.
29. It should be noted that in spite of their ratings still being of ‘investment’
grade, Portuguese banks had not tapped private financial markets for fund-
ing in more than a year because of unprofitable yields demanded by invest-
ors. Instead, the banks preferred to borrow from the ECB as part of the

25
 REVIEW OF INTERNATIONAL POLITICAL EC ONOMY

latter’s special crisis measures put in place to inject liquidities into the euro-
zone’s banking system in order to keep it functioning.
30. For details on Europe’s banking union, see Leblond (2014).

NOTES ON CONTRIBUTORS
Michele Chang is a Professor in the Department of European Political and
Administrative Studies at the College of Europe in Bruges, Belgium. She is vice
chair of the European Union Studies Association. She has received grants from
the Fulbright Program, the Deutscher Akademischer Austausch Dienst, the Insti-
tute of Global Conflict and Cooperation and the Picker Foundation. Her research
Downloaded by [College of Europe], [Michele Chang] at 07:52 21 August 2014

interests include European economic and monetary union, financial crises and
economic governance. Her upcoming book, Economic and monetary union, will be
published by Palgrave Macmillan in 2015.
Patrick Leblond is an Associate Professor in the Graduate School of Public and
International Affairs at the University of Ottawa as well as Research Associate at
CIRANO (Montreal). He is also Affiliated Professor of International Business at
HEC Montreal and Visiting Professor at the University of Barcelona (LL.M. in
International Economic Law and Policy [IELPO]) and the World Trade Institute
in Bern, Switzerland. He is a member of Statistics Canada’s International Trade
Advisory Committee and an advisor to the Canada-Europe Roundtable for Busi-
ness. Dr. Leblond has published extensively on financial and monetary integra-
tion, banking regulation, international trade and business-government relations,
with a particular focus on Europe and North America. Prior to moving to Ottawa,
he taught international business at HEC Montreal and worked in accounting and
auditing (he holds the title of Chartered Accountant) as well as in corporate
finance and strategy consulting for major international accounting and consulting
firms.

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