José Manuel González-Páramo: Sovereign contagion in Europe
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Distinguished Speaker Seminar of the European Economics
and Financial Centre, London, 25 November 2011.
* * *
Ladies and Gentlemen,
It is a great pleasure to speak to you here in London and discuss some key issues relating to
the ongoing crisis in Europe. For centuries the City of London has held its position as a
leading international financial centre. Few other places in the world exhibit such a high
density of expertise in financial matters. At the same time, where financial activity tends to be
concentrated experiences with financial contagion during crises are often also pronounced.
Let me cite a few excerpts from Walter Bagehot's "Lombard Street":1 "Mercantile bills are an
exceedingly difficult kind of security to understand ...in years like 1871 many active men
make so much money at the end of the year they are worthy of altogether greater credit than
anyone would have dreamed of....On the other hand, in years like 1866 a contagious ruin
destroys the trustworthiness of very many firms...Persons who buy and sell again soon are
often liable for amounts altogether much greater than their own capital; and the power of
obtaining those sums depends upon their "respectability," their "standing," and their
"credit,"...and more simply upon the opinion which those who deal with them have formed of
them."
Whilst not directly applicable to the present times and taken out of the historical context of
the financial panic around the failure of Overend, Gurney and Co. in 1866, there are still a
number of thought-provoking passages that sound so familiar in comparison with what we
have been experiencing over the past four years of financial crisis. This is not only the case
because the offices of Overend in Lombard Street were only a few miles away from where
we are meeting today.
So, let me dedicate my speech to the issue of contagion, and more specifically to the
experiences with sovereign contagion during the European debt crisis and the related policy
responses. I would like to start out by discussing why contagion needs to be addressed by
policy and how. Next, I shall review recent evidence of contagion phenomena across
European sovereigns. The third part of my speech will deal with how the European Central
Bank has responded to these developments; and the fourth part with the ultimate key
responsibilities pertaining to domestic fiscal authorities in this area and the need for
strengthened governance structures.
Financial contagion and public policy
Since the writings of Walter Bagehot financial contagion has become an issue that is
discussed widely in policy, market and academic research circles.2 Taking a broad
perspective embracing different views and studies, contagion could be defined as a situation
in which instability in a specific financial market, institution or country is transmitted to one or
several other markets, institutions or countries. A first characteristic of contagion is that the
spread of instability would usually not happen without an initial trigger event - which often
appears to be a relatively contained event. A second characteristic is that the transmission of
instability is in some way abnormal, for example, in terms of its speed, strength or scope.
Though spillovers are to be expected in an interconnected financial system, contagion is
distinct in that it often reflects a market failure and a dangerously amplified transmission of
instability.
The underlying market failure consists of the fact that contagion often involves externalities.3
As a result, the private costs of the initial financial market failure, that is the costs to the actor
triggering contagion, are lower than the social costs. In the specific case of the sovereign
debt crisis in Europe, the trigger could, for example, be that a country in a precarious fiscal
situation does not seriously implement the necessary fiscal consolidation measures. This
could lead interest rates on this particular country's government debt to rise and could in turn
also constrain economic growth in that country. This is what I call the "private costs" of such
behaviour. Although in this case the lack of fiscal discipline is something which is strictly
related to one country, this circumstance may still lead volatile financial markets to also lower
their expectations about fiscal consolidation efforts in other countries. As a result, those other
countries also begin to face costs in terms of significantly increased interest rates on their
government debt.
The social costs are in the end equal to the aggregate cost represented by the higher interest
rates that the governments of all the other countries have to pay for their debt because of the
fiscal irresponsibility of the original country.
The difference between private and social costs implies a market inefficiency calling for some
form of intervention whose objective is to internalise these kinds of externalities. In other
words, the countries that pursue activities which risk causing contagion need to be
constrained in pursuing such activities or "pay a price" which is proportional to the expected
costs to the other countries which are affected by the contagion. This provides them with
incentives to reduce the activities that could trigger contagion.
Given that the possibility of contagion is well known from the literature and economic history,
we should mind about both the preventive and corrective policies. In the case of sovereign
contagion preventive policy options would include, fiscal rules and governance mechanisms
that avoid excessive deficits or high stocks of public debt. Ex post policy options aimed at
addressing the fall-out from sovereign contagion would include liquidity provision by central
banks to financial markets, the recapitalisation of fragile banks and the swift implementation
of growth enhancing structural policies and fiscal adjustment measures to regain market
confidence in national economies and governments and offset the adverse effects of
contagion. It goes without saying that - as a rule - prevention is by far preferable to
addressing the problems that arise from contagion ex post. But I am afraid that the evidence
of contagion that I will present to you in a moment illustrates that we no longer have the
privilege of focusing on prevention alone.
Recent evidence on sovereign contagion in the euro area
There is a growing body of evidence which shows that contagion plays an important role in
the current crisis gripping the euro area - across sovereigns, across banks, and between the
two.4 While contagion has characterised the various stages during which the financial crisis
has become more acute through the end of this last summer, recent developments have
been indicative of a continuation - or even by some metrics an intensification - of contagion
forces. Perhaps the most potent illustration of this comes from studying the dynamics of a
specific recent episode where various aspects of contagion - notably the intense and
persistent transmission of idiosyncratic risks in a sequential manner - offer a compelling
narrative characterising developments.
The episode in question is the announcement by the Greek authorities on the first of
November that a referendum on the rescue programme agreed at the EU summit the week
before was being considered. The referendum was an event very specific to Greece. Indeed,
the fact that this day was a public holiday in parts of Europe implies that the news flow on
that day was more limited than usual.
In response to the announcement yields on Greek government bonds and Greek sovereign
CDS premia soared even further. The transmission of this shock to some other euro area
sovereigns and euro area banks, in particular, appears to have been rapid, large and
persistent. The CDS premia of France, Germany, Italy and Spain exhibited the largest
oneday increase of the year. But whereas the CDS premia of France and Germany quickly
receded to their previous levels, those of Italy and Spain further rose in subsequent days.
Movements in bond yields were comparatively muted, although Germany benefited from
strong safe haven flows.5
The above observations offer quite a compelling case for contagion, but such narratives are
still subject to the question of whether alternative interpretations of these events are possible.
It therefore makes sense to have a more systematic look at the data using empirical models
of contagion. For this purpose, ECB staff has developed and is extending an analytical toolkit
of models, which is "state of the art" in this area. Generally speaking, the results from these
multiple analyses tend to support the notion that contagion is indeed a driving force behind
the trends in the data. I would like to focus in particular on the results from two different but
complementary empirical approaches that sharpen the view on the existence and nature of
contagion occurring in the euro area over the course of this year.6
The first approach exploits the possibility of a persistent ability of idiosyncratic events in
Greek credit default swap premiums to predict developments in other euro area countries'
4
A previous account of this has been provided in a recent speech by my colleague Vítor Constâncio, who
described inter alia how contagion spread the sovereign debt crisis beyond the countries under EU/IMF
programmes over the summer (http://www.ecb.europa.eu/press/key/date/2011/html/sp111010.en.html). For
further discussions of the links between banking instabilities and sovereign debt problems, see V. Acharya,
I. Drechsler and P. Schnabl (2011), "A pyrrhic victory? - Bank bailouts and sovereign credit risk", NBER
Working Paper, no. 17,136, June, or A. Alter and Y. Schüler (2011), "Credit spread interdependencies of
European states and banks during the financial crisis", mimeo., University of Konstanz, June.
5
Like in previous episodes, such effects were not limited to sovereigns. The average CDS premium of a group
of 17 large European banking groups - none of which is Greek - showed the largest one day increase of this
year. Finally, also non-financial corporations were affected. The Eurostoxx 50 declined by 5.2% on the same
day, the third largest one day drop of this year.
6
Staff of the International Monetary Fund has found related evidence with different methodologies; see
C. Caceres, V. Guzzo and M. Segoviano (2010), "Sovereign spreads: Global risk aversion, contagion or
fundamentals", IMF Working Paper, no. WP/10/120, May, or R. Arezeki, B. Candelona and N. Sy (2011),
"Sovereign rating news and financial markets spillovers: Evidence from the European debt crisis", IMF
Working Paper, no. WP/11/68, March. See also G. Amisano and O. Tristani (2011), "The euro area sovereign
crisis: Monitoring spillovers and contagion", ECB Research Bulletin 14 (http://www.ecb.europa.eu/pub/pdf/
other/researchbulletin14en.pdf).
CDS premiums.7 Estimation proceeds in two stages, using multivariate frequency
decomposition. First, each CDS series is decomposed into long-, medium-, and short-run
shocks. Second, the long- and medium-run shocks of Greece, which are those that produce
lasting effects, are used to explain the CDS spreads of another euro area country, while
conditioning on the country's own shocks. If the additional explanatory variables improve
forecast accuracy over a 100-day horizon, the results from the model may be interpreted as
an indication that developments in Greece are causing contagion.
The results suggest that with the escalation of the sovereign crisis in July 2011, contagion
from Greece has become a source of systemic risk for several euro area countries.
Spillovers from the Greek sovereign crisis can explain the sharp deterioration in the
perceived creditworthiness of the other countries under EU/IMF programmes, Ireland and
Portugal that occurred in July 2011. Since July, this applies also to some of the larger euro
area countries such as Italy and even Germany. Moreover, the model indicates that the
spillovers from Greece are persistent and are thus likely to dissipate only slowly in the
presence of favourable developments.
Another model co-authored by ECB staff assesses the effect of an increased probability of
default of one country on the likelihood of default of other countries in the euro area,
controlling inter alia for the fact that the degree of interconnectedness in the system changes
over time.8 Let me emphasize that these default probabilities are estimated strictly on the
basis of the CDS premiums quoted in the market, irrespective of whether the probabilities
priced-in by the market are in line with the assessment made by official institutions. On the
basis of historical CDS data, these models, for example, find that a default in Greece
increases the probability of Portugal defaulting on its public debt by 30 percentage points.
The results of this model may be interpreted as providing some indication of sovereign
contagion effects from Greece to other euro area countries.
In sum, both descriptive and model-based evidence point to the presence of significant
sovereign contagion in the euro area. Moreover, these contagion pressures have recently
intensified, as they have spread beyond the euro area's periphery and have started to affect
larger economies. Following up on my earlier discussion on the policy-relevance of
contagion, policy makers need to address this. I shall address policy responses in two steps;
first, responses by the ECB and, second, responses by fiscal authorities.
Sovereign contagion, the monetary transmission mechanism and the ECB's Securities
Markets Program
The intensification over time of the sovereign debt crisis - as also illustrated by the contagion
evidence I have just referred to - has presented the ECB with the challenge of preserving the
proper functioning of the monetary policy transmission mechanism. In normal times the key
interest rates decided by the central bank have an initial impact on short-term interest rates
in the money market, and arbitrage relationships further propagate the policy impulse along
the maturity spectrum and across different asset classes. Coupled with adjustments of
money, credit and financing conditions, monetary policy can ultimately affect prices. The
smooth working of this transmission mechanism allows the central bank to fulfil its mandate
of maintaining price stability.
Security markets, especially sovereign bond markets, have traditionally come to play a
distinct role in the transmission of monetary policy in all advanced economies. This occurs
via three channels. First, government bonds are often used as a reference rate for pricing
loans or other asset classes. This is the so-called price channel. In particular, markets
generally consider that the credit standing of a sovereign has direct implications for the
creditworthiness of most private institutions within the jurisdiction of the sovereign itself.
Thus, sovereign yields provide generally a floor to the funding conditions of the private
sector. To the extent to which abrupt movements in yields carry the risk of spiralling off and
leading to contagion, credit intermediation suffers and there is an impairment in the
transmission of monetary policy. Second, government bonds usually provide a primary
source of collateral, given that they are generally the most liquid asset class. This makes
government bonds a prominent type of collateral in repurchase agreements. The disruption
of sovereign debt markets hampers the functioning of the interbank repo market and reduces
its liquidity. This leads to increased money market rates due to premia for liquidity risk, with
an impact on the capacity of banks to provide credit to the real economy. This is the
socalled liquidity channel. Third, changes in the valuation of bonds affect the behaviour of the
financial and non-financial sectors via their impact on the strength of their balance
sheet - this is the so-called balance sheet channel. For lenders, the lower capital base may
mean that they can supply fewer loans to the economy. By contrast, borrowers see their
creditworthiness reduced. This in turn limits their capacity to borrow. Concerning contagion, it
is clear that both contagion across sovereign bond markets and contagion between
sovereigns bonds and banks distort the working of all three channels on top of any
idiosyncratic market malfunctioning.
Faced with the risk of profound impairments of the transmission mechanism of monetary
policy, the ECB has adopted several non-standard measures in order to maintain a stable
relationship between its monetary policy stance and the conditions actually faced by
households and firms. I will focus here on the Securities Markets Programme (SMP) adopted
by the ECB in May 2010, given its direct relevance for addressing the malfunctioning of
security markets.
The programme was designed in the form of interventions in the euro area's securities
markets. The liquidity provided by the central bank via SMP interventions is fully re-absorbed
by other liquidity operations. The liquidity neutrality of the SMP interventions is one feature
making them distinct from "quantitative easing", which has the very purpose of increasing the
liquidity provided by the central bank.9 In addition, quantitative easing programmes have a
numerical target for the amount to be purchased. This is not the case for the SMP. Finally,
quantitative easing programmes have a much larger size, given their intended aim of
"flooding" the market with liquidity. A better-fitting analogy may therefore be drawn between
the SMP and sterilised exchange-rate interventions, which likewise do not necessarily have
an announced target and aim to correct a misaligned asset price.
To fully assess the impact of the SMP it would be necessary to know the counterfactual, that
is the situation that would have prevailed in the absence of the SMP. By definition this
counterfactual cannot be observed. There is, however, no doubt that through the purchases
of government bonds the SMP has contributed to restoring the monetary policy transmission
mechanism in the euro area. Other things equal, the programme also helped contain volatility
in the markets concerned.
It is essential that the nature of the SMP as a measure that supports the central bank in the
pursuit of its goal of maintaining price stability does not distort the incentive structure among
different policy actors that lie at the heart of EMU. For this reason, both when the SMP was
first announced in May 2010 and when its active implementation was confirmed in August
2011, the ECB took special note of the commitments of euro area governments to ensure the
sustainability of their public finances and address the shortcomings of economic governance
in the euro area.
Fiscal imbalances, governance in a Monetary Union and sovereign contagion
It is clear that a lasting solution to the current sovereign debt crisis requires making swift
progress in the consolidation of public finances, the boosting of sustainable economic growth
and the strengthening of the governance framework at the euro area level - to which I will
now turn.
The fiscal situation in euro area countries deteriorated significantly following the financial
crisis.10 In 2010, the aggregate fiscal balance of the euro area stood at more than 6% of
GDP, up from an almost balanced budget in 2000. The latest projections by the European
Commission suggest that the euro area deficit ratio would gradually decline to around 31⁄2%
of GDP in 2012. Euro area debt amounted to more than 85% of GDP in 2010 and would
increase to around 90% of GDP in 2012. Moreover, 14 out of 17 euro area countries are
currently facing an excessive deficit procedure related to a budgetary deficit above the 3% of
GDP reference value.
To be sure, the fiscal situation in the aftermath of the crisis is even worse in other major
economies. In the United States, for example, the 2010 deficit ratio stood at more than 10%
of GDP and the latest IMF projections suggest only a relatively limited decline to around 8%
of GDP in 2012. US debt reached around 95% of GDP in 2010 and would further increase to
around 105% of GDP in 2012. Japan and the UK ran similarly high deficits. In the case of
Japan, the deficit ratio amounted to around 9% of GDP in 2010 and, after an increase in
2011, would return to around this level in 2012. In the UK, according to the latest European
Commission forecast the deficit ratio would decline from 10.3% in 2010 to around 8 % in
2012.
Against this background, what are the reasons for the particularly severe disruptions in some
euro area sovereign debt markets and the related contagion effects, which are undermining
financial stability in the euro area as a whole? To approach this question it is helpful to take a
closer look at the specificities of the euro area institutional setup.
The combination of a single monetary policy and strongly decentralised fiscal policies
constitutes a specific feature of the euro area. The weak European governance has not been
able to remove incentives for national fiscal policymakers to allow the emergence of fiscal
imbalances in the form of running excessive deficits at the cost of other participating Member
States. The Stability and Growth Pact (SGP) was established to address such coordination
problems. However, it suffered from weak national implementation and a lack of enforcement
at the European level.
Enforcement of the SGP was built on a peer pressure mechanism among Member States. In
the past, however, Member States proved to be reluctant to enforce adequate fiscal
discipline on their peers. Moreover, decision-making bodies at the EU level were left with a
significant degree of discretion regarding the implementation of the fiscal rules, notably
following the 2005 reform.11
Incentives for ensuring sound national fiscal positions have as a consequence been
insufficient. Member States failed to adhere to their medium-term budgetary objectives and
only slowly corrected excessive deficits. As a result, a number of euro area countries
accumulated large fiscal imbalances already in "good times", instead of using opportunities
for reducing public deficits and debt levels. Therefore, they were left with hardly any room for
manoeuvre when the financial and economic crisis hit.
In the wake of the crisis, the substantial underlying fiscal and structural weaknesses in a
number of euro area countries, as well as the inability of the current governance framework
to prevent the emergence of such imbalances, became very apparent. Starting from the
collapse of Lehman Brothers in mid-September 2008, a regime switch in the pricing of
sovereign credit risk could be observed, from a pre-crisis situation of almost complete
compression of spreads to one of extreme market sensitivity to adverse country
developments. At the same time, the high degree of economic and financial integration in
EMU resulted in the fact that risks quickly spread to other Member States perceived as
vulnerable by the market. This happened, particularly, via national banking systems and their
exposure to sovereign credit risk. These developments illustrate how the emergence of
economic and financial imbalances laid the groundwork for the subsequent instability. The
experience of the crisis has also shown that in times of financial market stress the unravelling
of imbalances and contagion effects, which are both sources of systemic risk, often reinforce
each other.
As result, I think it is fair to say that we now stand at a crossroads and that decisive and
farreaching reforms will be necessary to address the sovereign debt crisis and ensure a smooth
functioning of EMU in the future. It seems that European policymakers have understood the
urgency of the situation and, fortunately, substantial reform steps have been initiated.
A governance reform package - the so-called "Six pack" - has been approved by the
European Council, the European Parliament and the European Commission in September
2011. It strengthens both the preventive and the corrective arm of the SGP and establishes
minimum requirements for national budgetary frameworks. At the European summit of
26/27 October 2011 governments announced further steps to enhance fiscal governance,
notably a strengthened surveillance of countries under the excessive deficit procedure and
the implementation of balanced budget rules in all euro area Member States.
Important steps have also been taken to strengthen the European Financial Stability Facility
(EFSF). The EFSF has been ratified by all 17 Member States of the euro area and
agreement has also been reached on leveraging existing EFSF resources in order to
increase the overall "firepower" of the fund without extending the guarantees underpinning it.
Conclusion
Looking ahead, the identification of the necessary reforms has to start from being clear about
what the ultimate objective is: the need to establish institutional arrangements which provide
credible incentives for sound fiscal and macroeconomic policies in a monetary union. In my
view, a more fundamental deepening of fiscal and economic policy surveillance is necessary
in the long run. This would involve a transfer of sovereignty to the European level of decision
making, which should have much stronger powers, and would also mean stricter constraints
on national budget policies.
This kind of reforms would require a comprehensive change to the EU Treaty but, above all,
an adequate mechanism to ensure their democratic legitimacy. Let me outline the ideal
cornerstones of such a governance reform. First, to ensure fiscal discipline, all planned
deficits of more than 3% of GDP and those in excess of a country's medium term objective
would need to be approved by all euro area governments. Second, past fiscal slippages
would be automatically corrected in upcoming budgets without any room for discretion via the
introduction of constitutional rules similar to the German "debt brake". Third, all Member
States would also agree to implement fines and sanctions in a quasi-automatic mode.
Finally, with the introduction in 2013 of a permanent crisis resolution mechanisms, the
European Stability Mechanism (ESM), those countries slipping in the progress with their
macroeconomic adjustment programmes would temporarily loose financial autonomy.
The institutional arrangements at both national and supranational level would also have to be
strengthened. At the national level, independent budget offices would ensure reliable
forecasts - a prerequisite for sound planning and implementation of budgets. At the euro
area level this needs to be complemented by an independent entity with a clear mandate and
a strong institutional framework to assess the implementation of fiscal rules. For instance,
this could be called a European Budget Office or "EBO", which could potentially form the
nucleus of what might become over time, and in a gradual manner, a European Ministry of
Finance. Strong and independent institutions at the euro area and national levels serve to
enhance transparency. They bring the necessary pressure to bear to ensure the conduct of
sound policies and effectively counteract possible tendencies towards a lenient
implementation of fiscal rules at the level of individual member states.
In addition to the "Six-pack" adopted in March 2011 the Heads of State or Government of the
euro area also agreed on a "Euro Plus Pact" to strengthen policy coordination with the aim of
improving competitiveness and convergence. Under this agreement euro area governments
commit to use a set of common indicators to regularly monitor each others progress in areas
such as labour-market reforms, reforms to wage-setting arrangements and reforms aimed at
improving the sustainability of pension, health care and social benefit systems. Governments
who signed the Euro Plus Pact also committed to translate the rules set out in the Stability
and Growth Pact into their national legislations. The reform of article 135 of the Spanish
constitution in August 2011, which for the first time introduced the principle of budgetary
stability into the fundamental law of the country, is a positive example of recent progress
made in this area.
As a final remark, let me emphasise once again that mastering the current crisis situation
requires that all parties involved honour their previous commitments. Most notably,
governments need to ensure, under any circumstances, the achievement of announced fiscal
targets and deliver the envisaged institutional and structural reform programmes. This is of
utmost importance for improving market confidence and regaining macroeconomic and
financial stability in the euro area.
Thank you for your attention.