Thursday, August 16, 2012

The euro and economic uncertainty in debt crises

by Jaime Luque and Abderrahim Taamouti


August 16, 2012

When economies are on the down, uncertainty is on the up – particularly during a crisis. But this column argues that the euro itself may have been a cause of uncertainty in the first place, long before the crisis.

The recent European debt crisis has hit several peripheral Eurozone countries. Problematic countries, such as Greece, Ireland, Portugal, Spain, and Italy, present high government debt levels and structural economic problems (see for instance Eichengreen 2010 on this site). Financing has become a difficult, sometimes impossible, task for them. Lenders are demanding high interest rates that are unsustainable in the long run. The public in general, and policymakers and economists in particular, have speculated on the reasons why uncertainty remained unsustainably high for these countries until they were forced to ask for a financial rescue, like in the case of Greece, Ireland, and Portugal. In this column we bring a new perspective for these episodes based on very recent empirical results from our research (Luque and Taamouti 2012).

Countries repeatedly return to debt markets to finance themselves, sometimes because of new investment opportunities that demand new financing, others following a Ponzi scheme. But any recurrent increment in government debt levels has been accompanied by higher uncertainty in debt markets, followed by higher interest rates on the countries' ten-year government bonds. In our research paper, we aim to investigate whether the effect of government debt and other fundamentals on economic uncertainty (measured by GDP growth rate volatility) is different before and after the adoption of the euro. Our main finding is that after the introduction of the euro, government debt had a positive effect on the economic uncertainty, whereas this effect was negative before the euro. The other economic fundamentals exhibit less structural change on economic uncertainty before and after the euro. Moreover, the comparison between euro and non-euro countries shows that our results are specific to the euro countries.


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