White Paper - DWS Investments

The Euro Crisis 

and Its Implications 

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DWS | GLOBAL FINANCIAL INSTITUTE 

July 2012 Dr. Bodo Herzog

2 

AUTHOR DWS | GLOBAL FINANCIAL INSTITUTE 

DR. BODO HERZOG 

Professor of Economics 

ESB Business School 

Reutlingen University 

Email: 

Bodo.Herzog@Reutlingen-University.de 

Web Page: 

Click here 

Dr. Herzog is professor of economics at ESB Business 

School, Reutlingen University. Moreover, he is Direc- 

tor of the Institute of Finance and Economics and a 

research professor at Reutlingen Research Institute 

(RRI). 

He has worked as a senior economist for the German 

Council of Economic Experts and as Chief Economist 

and Head of the Economics Department at Konrad 

Adenauer Foundation in Berlin. Professor Herzog 

studied mathematics and economics at the University 

Konstanz. He holds a PhD in economics with a disser- 

tation on fiscal-monetary interaction in the European 

Monetary Union. He was a research fellow at Massa- 

chusetts Institute of Technology. In addition, Professor 

Herzog is a regular visiting professor at Portland State 

University and Zeppelin University. Since 2008, Dr. 

Herzog is member of several political advisory coun- 

cils in Germany. 

Dr. Herzog’s research focuses mainly on macroeco- 

nomics, monetary economics, financial econom- 

ics, and neuro-economics. He has published many 

articles in professional journals and several academic 

books. He is a frequent columnist for “The European” 

magazine.

3 

TABLE OF CONTENTS DWS | GLOBAL FINANCIAL INSTITUTE 

TABLE OF CONTENTS 

Abstract .......................................................... 04 

1. Euro Crisis: What Are the Hidden Issues? ...... 0 5 

1.1. Current Account Imbalance: A Divergence 

of Competitiveness? ......................................... 0 5 

1.2. EMU’s Unique Institutional Rules: Friend 

or Foe? .............................................................. 08 

1.3. Re-Financing of Sovereign Debt: Merely 

Challenging in the EMU? .................................. 09 

2. Current Challenge in EMU: Contagious 

Sovereign Debt ............................................... 12 

2.1. Size of Government Debt .................................. 12 

2.2. Composition of Government Debt .................... 16 

3. Impact on the Real and Financial Economy ... 18 

3.1. Economic Effects of Debt Crises ...................... 18 

3.2. Economic Effects of Sovereign Spreads ........... 20 

3.2. Economic Effects of Austerity Measures .......... 23 

3.3. Public Debt Sustainability: Evaluation of 

Investors’ Decision-Making .............................. 24 

4. Policy Conclusions & Outlook ........................ 25 

References ..................................................... 27 

INTRODUCTION TO DWS GLOBAL FINANCIAL INSTITUTE 

Launched in November 2011, DWS Global Financial 

Institute (DGFI) is a new-concept think-tank that seeks 

to foster a unique category of thought leadership for 

asset management professionals in the global mutual 

fund investment community by effectively and taste- 

fully combining the perspectives of two worlds - the 

world of asset management and the world of aca- 

demia - concerning the economic, political, financial, 

and social issues facing the world. 

DGFI’s publications combine the views of DWS’ asset 

management experts with that of leading academic 

institutions in Europe, the United States, and Asia. 

The publications span a wide variety of academic fields 

from Macroeconomics and Finance to even Sociology 

in the form of research papers, interviews, debates, 

and more. 

Appendix .................................................... 28 

Endnotes .................................................... 31 

5. Investor´s Corner ........................................ 32

4 

THE EURO CRISIS AND ITS IMPLICATIONS DWS | GLOBAL FINANCIAL INSTITUTE 

The Euro Crisis and Its Implications 

Dr. Bodo Herzog 1 

July 2012 

White Paper in Cooperation with DWS Investments 

ABSTRACT 

In this white paper, we explain the key forces behind 

the euro crisis and analyse its impact on government 

and investor decision-making. We argue that as long 

as existing macro dynamics, especially current account 

imbalances and high levels of debt, are not reversed, 

the euro area will remain in crisis mode. Furthermore, 

contagion has the potential to create an immediate 

crisis of confidence and amplify existing challenges. 

We find that, with a few exceptions, euro area govern- 

ment debt is similar in size and composition to pub- 

lic debt of countries outside the euro. However, the 

market reaction has been exaggerated in Europe due 

to the continent’s unique institutional framework. The 

United States, United Kingdom, and Japan are by no 

means in a better position in the long run. We con- 

firm the hypothesis that Greece is an exceptional case. 

In addition, we argue that it is almost unmanageable 

for Greece to regain competitiveness by more than 

20% within the straitjacket of the European Monetary 

Union. Our empirical analysis of debt crises demon- 

strates a long-lasting negative impact on economic 

output and loan policies. Thus, the economic outlook 

for the indebted countries is gloomy. Tackling the roots 

of the euro crisis should therefore be the top priority 

on the policy agenda. We provide a novel toolbox for 

investors’ assessment of sustainable public finances 

that will enhance their decision-making in sovereign 

bond markets. 

Key words: EMU, Sovereign Debt, Sustainability, 

Macroeconomic Implications 

1 Dr. Herzog is Professor of Economics at ESB Business School. He is also research professor at RRI Reutlingen Research Institute and Director of the Institute of Finance and Economics at ESB Business School 

and KFRU Reutlingen University. Contact address: Alteburgstr. 150, 72762 Reutlingen, Germany. Email: Bodo.Herzog@Reutlingen-University.de 

Acknowledgement: I am grateful for very helpful comments from Henning Stein, Johannes Müller, and Jun Shiomitsu. Moreover, special thanks to both Katja Hengstermann and Cristina Debora Manea for 

outstanding editing. I am responsible for all remaining errors.

5 THE EURO CRISIS AND ITS IMPLICATIONS 

EURO CRISIS: WHAT ARE THE HIDDEN ISSUES? 

The European Monetary Union (EMU) is in crisis. With- 

out a doubt, the rescue packages of the past several 

years were necessary to stabilize the euro area and the 

financial markets in the short term. However, it is ques- 

tionable whether this rescue path will lead to a sustain- 

able framework of economic governance. There is a 

danger that policymakers will follow the wrong path, 

leading to a future break-up of the euro area. The cur- 

rent rescue philosophy of helping the indebted coun- 

tries with guarantees on the one hand and demand- 

ing austerity on the other hand is appropriate only as 

a short-run stabilization tool and does not solve the 

structural problems in the medium and long term (Her- 

zog 2011, 2012). An effective solution requires a pro- 

found analysis of the structural and hidden issues of 

the so-called euro crisis. In addition, we address the 

question: What will be the impact on investors? 

The euro faces a crisis with multi-dimensional roots. 

One facet is the sovereign debt crisis, which started in 

the spring of 2010 and has now turned into a crisis of 

confidence that continues to spread and has already 

affected five euro member states – Greece, Portugal, 

Ireland, Spain, and Italy – that together account for 

one-third of the EMU’s economic output. The pres- 

ent uncertainty has triggered an additional decrease in 

consumer and investor confidence, further weakening 


the economic outlook. The typical self-reinforcing and 

contagious processes now threaten the very existence 

of the monetary union. Given that regulators continue 

to classify bonds as absolutely secure assets, it is cru- 

cial to ensure that current liquidity problems do not 

culminate in an overall solvency crisis. 

Investors’ distrust in the solvency of the euro area 

can be inferred from the development of default risk 

premiums on European sovereign bonds and CDS 

spreads. Remarkably, the current state of financial 

turmoil has impaired the creditworthiness of mainly 

euro area banks. Figure 1 shows that CDS spreads of 

euro area banks are now higher than they were fol- 

lowing the collapse of Lehman Brothers in September 

2008, while CDS spreads for U.S. banks remain below 

that level (Figure 1). Hence, this chart demonstrates 

the effect of “contagion” in the euro area. The next 

subsections provide a rigorous diagnosis of the root 

causes and hidden issues of the euro crisis. 

1.1 Current Account Imbalance: A Divergence of 

Competitiveness? 

For more than two decades, economists have dis- 

cussed the threat posed by uncontrolled reversals 

Figure 1: CDS Spreads For Monetary Financial Institutions in the Euro Area and United States 

Source: Thomson Financial Datastream (2011,2012).


of global imbalances to individual countries and the 

global economy. Not surprisingly, global imbalances 

expanded massively leading up to the financial crisis 

of 2007 and thereafter declined significantly (Figure 

1A-Appendix; IMF 2010). A similar pattern, though to 

a smaller degree, is observable within the euro area 

(Figure 2). 

A closer look at Figure 2 reveals that Spain, Italy, 

Greece, and Portugal were the biggest deficit coun- 

tries, while Germany and the Netherlands were the 

major surplus countries. The current accounts of the 

other deficit or surplus countries are negligible. If we 

calculate the current account relative to GDP, however, 

we immediately identify Greece, Portugal, Spain, and 

Ireland as the biggest deficit countries. Ireland and 

Spain are two particularly special cases because both 

featured sound public finances before the onset of the 

financial crisis. The problem in Spain and Ireland was 

the relatively high level of private debt, i.e. household 

and corporate debt. The debt accumulation was trig- 

gered by historically low (real) interest rates since the 

beginning of the EMU in 1999. Consequently, both 

economies experienced an unsustainable investment 

and housing boom. Figure 3 shows that high private 

deficit-to-GDP is not just prevalent in the troubling 


Figure 2: Current Account in Billions of USD of Selected Euro Area Countries in 2010 

euro area countries, but also in the U.S. and Iceland 

(not reported). 

Source: IMF (2011,2012). 

The current account imbalances and high private defi- 

cit and debt levels are closely linked to the euro cri- 

sis. Financial institutions relocated the high savings of 

surplus countries – Germany, for instance – to deficit 

countries in order to finance household and corporate 

loans. Due to the typical home bias in investment, the 

lion’s share of savings simply moved from core Euro- 

pean surplus countries to periphery deficit countries. 

The irrationality of this process is reflected in the fact 

that mortgage interest rates in Spain and Ireland were 

lower than in Germany even though Spain and Ireland 

had higher private debt levels and, consequently, car- 

ried higher default risks. In addition to private debt 

accumulation, countries such as Greece, Portugal, and 

Italy accumulated huge public debt in the run-up to the 

financial crisis. There is evidence that the major deficit 

countries avoided sufficient budget consolidation dur- 

ing the economically good years. Furthermore, with 

the onset of the financial crisis, governments around 

the globe implemented substantial stimulus measures 

and financial guarantees in order to stabilize the finan- 

cial sector and real economy. These policy measures


increased public debt even further in a relatively short 

period of time. As a result, markets questioned the 

sustainability of public finances in the heavily indebted 

countries, leading to a widening of sovereign bond 

spreads and CDS spreads since 2010. 

Ireland slipped into sovereign debt problems for differ- 

ent reasons from those of Greece and Portugal. Greece 

and Portugal are victims of inherently high public debt 


Figure 3: Private Sector Deficit-to-GDP 1 for Selected Countries in 2007 

Source: IMF and own calculations (2011,2012). 

levels, while Ireland’s problems were caused by high 

private debt levels and extensive public support for the 

banking sector during the financial crisis. Euro area 

contagion in turn affected the other countries, like 

Spain and Italy, soon thereafter. Thus, the overlap of 

both trends – massive private and public debt accu- 

mulation as well as public support to the financial sys- 

tem – is the major force behind the euro crisis. 

Figure 4: Unit Labour Costs of Selected Euro Area Countries (Index 2000 = 100) 

Source: Eurostat (2011,2012).


Figure 5: Productivity and Labour Costs 

(annual average between 2000 and 2010 in %) 

In addition to these problems, the five troubled coun- 

tries – Greece, Portugal, Spain, Italy, and Ireland – 

declined substantially in competitiveness over the 

past decade. Wages rose faster than productivity for 

years, meaning that their unit labour costs, relative to 

their major rivals, were about 20% higher than in 2000 

(Figure 4 on previous page). Given that none of the 

countries is able to make adjustments via a nominal 

devaluation, the only way out is via painful nominal 

wage cuts. This does improve competitiveness, but it 

also exacerbates the debt problems of private house- 

holds. While the current unit labour costs for the five 

countries is insufficient to regain an average level, 

there have been some positive signs. Since 2008, Ire- 

land has been making significant corrections to regain 

competitiveness. The picture for Italy is a bit more 

controversial. The trend in unit labour costs is still 

upwards despite some positive political reform steps 

since 2011. Nevertheless, there remains a divergence 

between these countries’ unit labour costs and those 

of the surplus countries. 

It turns out that the divergence of the unit labour costs 

is not caused by insufficient productivity growth in 

the five troubling countries, but rather by the wrong 

adjustment of nominal wages according to productiv- 

ity (Figure 5). There is empirical evidence that deficit 

countries increased wages more than surplus coun- 

tries. Almost all Southern European states still have 


Source: Eurostat and own calculations (2011,2012). 

so-called wage-indexation rules. The nominal wage is 

thus not linked to productivity growth but to inflation. 

In short, the key macroeconomic forces behind the 

euro crisis are the current account imbalances and 

declining competitiveness of countries in the euro 

area. Historically low interest rates also triggered pri- 

vate and public debt accumulation before the onset of 

the financial crisis. These reckless market conditions 

caused an artificial economic and wage boom that 

eroded the competitiveness of some countries during 

the period from 2000 to 2008. Finally, fiscal measures 

to stabilize the financial sector and real economy raised 

concerns about the sustainability of public finances in 

these euro area countries. 

1.2 EMU’s Unique Institutional Rules: Friend or 

Foe? 

Another special characteristic of the euro crisis is the 

institutional straitjacket of the monetary union. A com- 

parison with highly indebted G-7 member states, such 

as Japan, the United Kingdom, and the United States, 

shows that the euro area has less flexibility with cen- 

tral bank bond-buying programs and state support (cf. 

section 2). In addition, the U.S. is in a unique position 

due to the safe-haven status of the dollar. 

The EMU fundamentally changed the framework of


European governance and monetary policy. Member 

states issue debt denominated in euros, but lack their 

own central banks to create the means to repay their 

debts. European member states assumed that the 

spill-over risk of default was eliminated by institutional 

rules, such as the no-bailout clause and the Stability 

and Growth Pact implemented in 1997. These rules 

were meant to guarantee that unsound fiscal policy 

and thus default were solely national, rather than Euro- 

pean, issues. However, as early as the 1990s, many 

experts realized that the no-bailout clause lacked cred- 

ibility. When faced with severe turmoil it was expected 

that the rules would be abandoned. This was the case 

in 2005, when the Stability and Growth Pact was 

revised, as well as in 2010, when the no-bailout clause 

was abolished at the onset of the sovereign debt crisis 

in Greece. 

The existing shortcomings of economic governance 

within the EMU have been discussed since 2003. 

From the beginning, the enforcement mechanism of 

the stability pact was identified as too weak and the 

sanction scheme as too inconsistent. Accordingly, the 

institutional framework established little discipline. 

Although Greece consistently ran deficits in excess 

of 3% of GDP and maintained debt levels above 60% 

of GDP, European policymakers failed to demand the 

obligatory austerity measures. Now, more than 10 

years later and in the heat of crisis, policymakers are 

demanding such austerity. There is no doubt that these 

measures are necessary, but the implementation came 

far too late. EMU’s institutions and policymakers failed 

to create strong disciplinary incentives. 

Furthermore, during normal times financial markets – 

banks, insurance companies, and rating agencies, in 

particular – failed to sufficiently differentiate the cred- 

itworthiness of euro area countries. This is astonish- 

ing since the legal and institutional framework of the 

EMU, including the assigning of responsibility for the 

soundness of fiscal policy to national governments, 

has been clear since the beginning of the monetary 

union. The reasons for this partly “irrational” market 

opinion on creditworthiness, aside from the clear lack 

of credibility of the no-bailout clause, are still unclear. 

It could be due to misunderstandings on the part of 


financial investors or the lack of credibility and disci- 

plinary incentives in the institutional setup of the EMU. 

Fortunately, since 2010, financial markets have 

responded with a differentiated assessment of the 

creditworthiness of sovereign bonds. However, the 

relatively abrupt reversal of sovereign yields has pro- 

duced a situation similar to a bank run in the euro 

area. These self-reinforcing and systemic effects have 

been highly “contagious” – that is, they have cre- 

ated temporary liquidity problems that have evolved 

into enduring solvency crises in some countries. This 

can be attributed to the fact that a country’s solvency 

depends firstly on the interest rate it has to pay for 

its debt and secondly on its expected economic out- 

look, both of which have deteriorated in the problem 

countries. 

The unique institutional setup of the EMU, combined 

with ongoing uncertainty and self-reinforcing pro- 

cesses, has the euro area facing a crisis of confidence. 

This is nicely illustrated by Standard & Poor’s justifi- 

cation for downgrading Italy in September 2011, in 

which the agency noted that Italy is expected to pay 

higher interest and that the country’s austerity pro- 

gram has weakened output. Both factors – lower GDP 

and higher interest rates – increase debt levels. This 

leads to a vicious cycle in which higher debt leads to 

even higher interest payments and slower growth. 

Simply put, this assessment is always true and justifies 

a downgrade at all times. Surprisingly, this argument 

was not applied to, and the market reactions were 

subdued for, countries with similar debt levels such as 

the U.K., U.S., and Japan. Consequently, the unique 

institutional framework of the European Monetary 

Union triggered substantial downgrades and snowball 

effects that led to a surge in bond yields in the heavily 

indebted countries. In summary, specific institutional 

issues explain why the EMU faces unusually tough 

challenges compared to other countries with similar 

debt levels. 

1.3 Re-Financing of Sovereign Debt: Merely Chal- 

lenging in the EMU? 

Finally, we discuss the sovereign debt dimension


Figure 6: 10-Year Bond Rates in Selected Countries, in % 

and the currency perspective of the euro crisis. High 

sovereign debt levels triggered an extraordinary yield 

dynamic, signalling a crisis of confidence in the euro 

area. Judging the solvency and sustainability of a 

country’s public finances, however, requires a general 

equilibrium assessment of the debt-to-GDP ratio over 

time. This issue is studied in subsection 3.4 based on 

new estimates. 

Despite considerable efforts to consolidate budgets 

in Greece, Portugal, Ireland, and Spain, the impact on 

bond rates was negligible in 2011 (Figure 6). These 

countries reduced their primary balance – public 

deficits excluding interest payments on government 

liabilities – in the years 2009 to 2011 by 7.6 percent- 

age points. Highly indebted G-7 countries, such as 

Japan, the United States, and the United Kingdom, 

are far behind this. Nevertheless, bond rates in these 

countries dropped 1 percent, while rates for the five 

indebted euro area countries climbed even further. 

This dynamic is a bit surprising. For instance, Japan 

has a very high debt-to-GDP ratio of 213% and has 

a quickly ageing population. Nevertheless, Japan, as 

well as the U.S. and the U.K., is still able to finance itself 

in the capital market at interest rates similar to the low 

rates paid by Germany, which features much sounder 

public finances. This market paradox can be explained 

by the EMU straitjacket. The EMU’s one-size-fits-all 


Source: Thomson Financial Datastream (2011,2012). 

monetary policy and the lack of exchange-rate depre- 

ciation for euro area countries are both major prob- 

lems helping to fuel the crisis. 

The markets are by no means impressed by the tough 

austerity programs of EMU countries. Financial mar- 

kets even perceived higher default risks for the five 

euro area countries, which triggered contagious 

effects. Markets are strongly disappointed with struc- 

tural debt problems in the euro area. One aspect is that 

the government’s accumulation of debt was not fully 

offset during economic good times in past decades. 

Moreover, the government’s indebtedness will soon 

become even more difficult to manage due to Europe’s 

ageing population. 2 

Given the risk of self-reinforcing spirals, and the fact 

that the European Central Bank (ECB) is the only 

institution capable of acting in the short run, the 

unique institutional problems in the euro area are still 

unsolved. Only with a time delay did policymakers 

agree to implement the European Financial Stability 

Facility (EFSF), with about €440 billion. The EFSF will 

be converted to the European Stability Mechanism 

(ESM) after a transitory overlap of both rescue facili- 

ties. The ESM is another step forward; however, there 

are several flawed incentives within the ESM proce- 

dure. This rescue umbrella might be too low compared 

to the Italian and Spanish refinancing requirements of


approximately €1.1 trillion in the years 2012 and 2013 

(Table 1). Table 1 shows the refinancing requirements 

of selected euro area countries. These amounts indi- 

cate an urgent need to tackle the roots of the euro 

crisis. Nonetheless, the crisis with respect to Greece, 

Portugal, and Ireland is manageable. As markets calm 

down and eventually return to normal, refinancing via 

capital markets might be achievable. 

Indeed, the period of the so-called “Great Modera- 

tion” – which was characterized by relatively low inter- 

est rates and low volatility – contributed to today’s 

problem. First, it triggered excessive risk taking and 

maturity transformations. Second, there is empirical 

evidence that the more integrated and liberalized the 

financial system, the higher the co-dependence of 

the default risk of publicly traded banks (Anginer and 

Demirguc-Kunt 2011). Consequently, the generous 

global liquidity conditions and lack of global supervi- 

sion created a hidden instability in the financial and 

macroeconomic environment. Research provides sig- 

nificant evidence that both factors are key drivers of 

booms in credit markets (Elekdag and Wu, 2011). 

In summary, the so-called euro crisis is definitely not 

a crisis of the euro currency. Despite the weaker euro- 

dollar exchange rate in recent months 3 , the euro is 


Table 1: Refinancing Requirements of Selected Euro Area Countries in 2012 and 2013 

Source: IMF and own calculations (2011,2012). 

still the second-largest reserve currency according 

to recently published data by the IMF. From 1999 to 

2011, the share of U.S. dollar reserves has declined 

from 71.0% to 61.7%, while euro reserves increased 

from 17.9% to 25.7%. This trend demonstartes the 

increasing demand for the euro currency. In fact, 

according to interest-rate parity, the recent drop of the 

euro can easily be explained as a temporary phenome- 

non. Moreover, since December 2010, there has been 

explicit political willingness and action to tackle the 

roots of the European sovereign debt crisis. It is not 

just talking, as it was in the previous years; now there 

is bold and decisive action. Policymakers agreed to 

implement constitutionallly alike national debt rules in 

25 euro area countries (though not in the United King- 

dom or Czech Republic). In March 2012, they ratified 

the fiscal compact, which is all in all another positive 

sign. 4 In addition, European policymakers reformed the 

existing economic governance of the euro area by the 

so-called six-pack reform. Altogether, this is certainly a 

step in the right direction, but it is not a quantum leap. 

There are two options in the long-run: 

• Option A (centralization): This is a fundamental 

change in the existing policy framework toward a 

transfer union with Eurobonds and a European finance 

minister, budget, and taxes. This option would insist


that EMU member states abandon a substantial part of 

their national sovereignty over fiscal policy. This would 

require immediate and fundamental legal changes at 

both the European and national level. The recent judg- 

ment by the constitutional court in Germany has partly 

eliminated this option for the near future. 

• Option B (decentralization): This is an effective, 

de-politicized, rules-based framework aligned with 

market forces and consistent institutional incentives. 

This would strengthen the fiscal and market incentives 


for sound finances in the long run and enhance the 

consistency of the institutional setup. Thus, Option B 

requires a return to and enhancement of the funda- 

mental principles of the existing monetary union. 

Either option would be effective as a solution from an 

economic point of view. However, a combination of 

options A and B – that is, sharing the costs of unsound 

fiscal policy while retaining national sovereignty over 

fiscal policy – is likely to fail. 

2. CURRENT CHALLENGE IN EMU: CONTAGIOUS SOVEREIGN DEBT 

This section explains the challenges of public debt 

accumulation in Europe and its policy implications. 

We argue that the total amount of government debt 

consists of explicit and implicit debt. Market partici- 

pants and rating agencies often overlook the “hidden 

debt” in the form of implicit and contingent liabilities. 

In addition, the composition of public debt provides 

valuable information about the maturity and holder 

of sovereign debt. Consequently, the debt’s composi- 

tion plays a key role when evaluating the solvency and 

vulnerability of public finances. Policy conclusions are 

that: (i) Debt ratios must be stabilised to re-establish 

market confidence; (ii) implicit or off-balance-sheet 

Table 2: Government Debt-to-GDP in the Euro Area (2007-2012) 

government debt must be monitored carefully and 

taken into account for a more comprehensive analy- 

sis of sustainable public finances; and (iii) deficit and 

gross debt should remain the basis for the “Excessive 

Deficit Procedure” within the Stability and Growth 

Pact. However, these should be analysed with the ulti- 

mate goal of a balanced budget in the medium term. 

2.1 Size of Government Debt 5 

The financial, economic, and sovereign debt crises 

of the past few years have imposed a substantial fis- 

cal burden on governments. In all countries, stimulus 

Percentage of GDP 2007 2008 2009 2010 2011 2012 

1 Gross Debt 66.2 69.9 79.3 85.2 87.7 88.5 

2 Change in Debt Ratio (2 = -3+4+5) -2.3 3.6 9.5 6.0 2.4 0.8 

3 Nominal GDP growth -3.5 -1.6 2.3 -2.0 -2.5 -2.9 

4 Deficit 0.7 2.0 6.3 6.0 4.3 3.5 

Automatic stabilisers -1.0 -0.5 2.0 1.6 1.3 1.0 

Other expenditures 1.7 2.5 4.3 4.4 3.0 2.5 

5 Deficit-debt adjustment 0.5 3.2 0.9 1.9 0.6 0.2 

Support of financial sector 0.0 1.9 0.5 2.5 - - 

Ohter expenditures 0.5 1.3 0.4 -0.6 - - 

Source: ECB and European Commission (2011,2012).


Table 3: Debt-to-GDP for Euro Area Countries 

Year 1999 2007 2010 

Austria 58 58 70 

Belgium 110 84 96 

Cyprus 43 45 61 

Germany 61 65 82 

Estonia 2 1 1 

Spain 61 36 61 

Finland 37 34 47 

France 59 64 82 

Greece 70 107 142 

Italy 109 103 118 

Luxembourg 6 7 19 

Malta 45 59 69 

Netherlands 61 45 60 

Slovenia 11 23 39 

Slovakia 31 21 41 

Portugal 50 68 93 

Ireland 48 25 96 

Source: ECB and European Commission (2011,2012). 

spending during recession years has led to sharp 

increases in debt-to-GDP and deficit-to-GDP ratios. 

This has had adverse consequences on sovereign 

bond yields, private investments due to crowding 

out, and potential output. Moreover, these increases 

affected markets’ confidence in government liquidity 

and solvency. 

A government is called solvent in a given period if the 

discounted value of its current and future budget bal- 

ance surpluses is higher than the sum of the initial 

stock of debt. In the European context, we define the 

60% debt-to-GDP limit as a threshold. A government 

is called liquid if the available government’s liquid 

assets in a given currency are in line with its maturing 

liabilities. Hence, the maturity profile of government 

debt, including the refinancing needs of outstanding 

short-term debt, is relevant for analysing liquidity. 

The euro area’s gross public debt-to-GDP ratio 

increased over the period of 2007 to 2012, from 


66.2% to 88.5%. The level of government debt in 2012 

is expected to increase by almost €2.7 trillion from a 

stock of about €6 trillion in 2007. The volume of gov- 

ernment bonds in the euro area is estimated to be as 

high as €7.822 trillion euro in 2010. The major sover- 

eign debt holders are the monetary financial institutes 

(MFIs) with 35% or €2.746 trillion, insurance compa- 

nies and pension funds with 16% or €1.215 trillion, 

and investment funds with 9% or €692 billion. The 

remaining 40%, or €3.17 trillion, is held by others, 

including foreign investors and hedge funds. Auto- 

matic stabilisers, expansionary counter-cyclical fiscal 

policies, and government support to the financial sec- 

tor during the financial crisis of 2007 to 2009 drove the 

recent public debt accumulation (Table 2). However, 

stabilization expenditures have been somewhat erratic 

across countries, particularly in Germany, the Nether- 

lands, Portugal, and Ireland. 

In 2009, the severe recession and resulting negative 

output gap added to debt accumulation by 2.3 per- 

centage points. In all other years, GDP growth has 

slightly reduced future debt levels (cf. row 3), even if 

the net contribution to debt was mostly positive, as 

shown in row 2 in Table 2. Line 5 in Table 2 justifies the 

hypothesis that the recent debt accumulation in the 

euro area is also caused by deficit deterioration due 

to public stimulus and support to the financial sector. 

Consequently, debt-to-GDP ratios increased in almost 

all countries. Let us compare the debt levels of 2007 

and 2010: Ireland’s debt increased by roughly 71 

percentage points, Greece’s by about 35 percentage 

points, and Portugal’s and Spain’s by around 25 per- 

centage points (Table 3). In addition, Table 3 illustrates 

that more countries breached the 60% debt-to-GDP 

threshold in 2010. The variety of deficit-to-GDP levels – 

not explicitly reported here – is also remarkable, rang- 

ing from double-digit deficits in Ireland and Greece to 

deficits below 3% of GDP in Luxembourg and Finland, 

and even a small surplus in Estonia. 

By the end of 2011, debt ratios in most euro area 

countries exceeded the 60% threshold with only a few 

exceptions. Interestingly, there is also a split in short- 

term and long-term outsanding debt in the euro area.


For almost all countries, with the exception of Estonia 

and Luxembourg, long-term debt securities are well 

above 60% of GDP. Nevertheless, those dynamics and 

high debt levels are not hopeless. The Netherlands, 

for example, was able to reduce its debt by around 

138% of GDP in just ten years from 1946 to 1956. This 

gigantic consolidation effort was mainly accomplished 

with sustained economic growth and double-digit sur- 

pluses during this time period. 

A comprehensive evaluation of the euro area’s situ- 

ation requires a comparison with its competitors, 

including the U.S., the U.K., and Japan. A trivial direct 

comparison of public finances is not possible with- 

out some careful adjustments due to methodological 

and statistical differences across countries. In Japan, 

for instance, debt and deficit statistics are compiled 

according to System of National Accounts 2008, while 

in the U.S. it is based on the National Income and 

Product Accounts (NIPA) methodology. All account- 

ing frameworks are slightly different and comparison 

requires careful adjustment and interpretation. 

We apply the European definition of government debt 

and calculate the debt levels for the U.S., Japan, and 

Europe in Figure 7. 6 The graph shows an increasing 

debt-to-GDP ratio between 2007 and 2010 of approxi- 

mately 19 and 29 percentage points in the euro area 

and U.S., respectively. In Japan, the debt ratio was at 

180.4% in 2009 and rose about 60 percentage points 

in the last 10 years, due to high deficits and low GDP 


Figure 7: Debt-to-GDP from 1997 to 2010 (left) and Deficit-to-GDP in 2010 (right) 

growth. According to our calculations, U.S. net debt 7 

has a similar magnitude to that of the euro area. Even 

more striking is a comparison of government deficits. 

In 2010, the euro area deficit situation was relatively 

modest compared to those of Japan, the United King- 

dom, and the United States (Figure 7). 

Next, we give a detailed analysis of the indirect debt 

burden and contingent liabilities, such as guarantee 

schemes provided to secure the financial sector and 

special-purpose vehicles, also known as “bad banks.” 

Table 4 shows the cumulative amount of contingent 

liabilities as a result of the stabilisation operations car- 

ried out in the financial sector during the years from 

2008 to 2010. The first column in Table 4 depicts the 

total impact on government debt in percentage of 

GDP due to financial sector stabilization (i.e. acquisi- 

tion of shares, loans, asset purchases, and other mea- 

sures). The second column represents the total impact 

on government-contingent liabilities. On top of these 

implicit state guarantees we have to add explicit state 

guarantees of the EFSF today or the ESM in the future 

(columns 4 and 5). 

Source: ECB (2011,2012). 

The average grant guarantee of the euro area is 6.5% of 

GDP (bottom line in column 2). Most notably, the Irish 

government has provided vast guarantees of 125% 

of GDP. The fiscal risks of these guarantees depend 

on the probability of default, so there is no immediate 

impact on public deficit and debt. The financial trans- 

actions tax currently being discussed as a means to


Table 4: Cumulative Financial and Public Sector Stabilisation 

finance future default costs is therefore questionable 

if not implemented globally or in Europe at all. Unfor- 

tunately, this tax unencumbers mainly public but not 

private debt. In the end, the transaction tax is paid by 

consumers, not by the financial sector. Moreover, as 

long as this tax is not introduced internationally, it may 

just slow market processes or reduce volatility trig- 

gered by traders in the euro area. 

For the current discussion about the sovereign debt 

crisis and high debt levels, the fact that the current 

EFSF guarantees have not yet had an impact on debt 

is of great importance. Even the paid-in capital of 

€80 billion to the ESM will not increase government 

debt because the paid-in capital will be treated as 

direct loans from an international organisation, such 

as the IMF. According to the definition of the public 


Financial Stabilization 2008-2010 ESM (European Stability Mechansim) 

Total Impact Total impact on ESM Subscribed Paid-in Capital 

on Debt contingent liabilites Capital in bn € in bn € 

in % of GDP in % of GDP 

Belgium 5.8 15.8 24.3 2.8 

Germany 13.5 2.8 190.0 21.7 

Estonia 0.0 0.0 1.3 0.1 

Ireland 23.2 125.2 11.1 1.3 

Greece 2.3 25.1 19.7 2.3 

Spain 2.4 5.6 83.3 9.5 

France 0.2 4.7 142.7 16.3 

Italy 0.3 0.0 125.4 14.3 

Cyprus 0.0 17.2 1.4 0.2 

Luxembourg 6.1 3.2 1.7 0.2 

Malta 0.0 0.0 0.5 0.1 

Netherlands 9.0 6.8 40.0 4.6 

Austria 2.6 7.8 19.5 2.2 

Portugal 3.6 3.1 17.6 2.0 

Slovenia 4.0 6.1 3.0 0.3 

Slovakia 0.0 0.0 5.8 0.7 

Finland 0.0 0.0 12.6 1.4 

Euro Area 5.5 6.5 700.0 80.0 

accounting standards, this does not affect the explicit 

debt-to-GDP ratio; however, it will raise implicit debt 

levels. 

Source: ECB and EU Commission (2011,2012). 

This issue of implicit debt leads to a very important 

point: Explicit public debt levels are often biased sig- 

nificantly and do not give valid information about the 

sustainability of fiscal policy. Thus, the evaluation of 

the size of government debt requires the measurement 

of explicit and more importantly implicit government 

debt, namely, future debt from current government- 

managed pension schemes unrecorded in official sta- 

tistics. Table 5 provides a rough overview of implicit 

government liabilities for selected euro area countries. 

The total (explicit and implicit) debt stock in the euro 

area is estimated to be 330% of GDP (Mink et al. 2008).


Table 5: Implicit and Explicit Debt (2008) 

( % of GDP) 

Social Defined-Benefit 

Security schemes 

Germany 275 47 

France 292 60 

Italy 322 1 

Euro Area 278 52 

Source: Eurostat and ECB (2011,2012). 

Germany stands out with the lowest ratio, due to past 

reforms in the social security and pension systems. 

Nevertheless, accurate interpretation is tricky because 

these numbers are based on estimations and rely on 

long-term assumptions about future economic perfor- 

mance. In addition, we must take into consideration 

increasing government costs due to an ageing pop- 

ulation. The increase of ageing-related government 

expenditure relative to GDP over the period of 2007 

to 2060 is estimated to be 5.2 percentage points for 

the euro area. The highest demographic cost share in 

the euro area is expected in countries such as Greece, 

Cyprus, Luxembourg, Malta, and Slovenia, rang- 

ing from 10% to 18%. The lowest share is expected 

in Estonia, 0.4%. Germany’s expenditures related to 

demographic challenges are expected to be around 


4.8% of GDP, close to the euro area average. The main 

message from these projections is that future primary 

budget deficits, and therefore debt-to-GDP ratios, will 

rise even further if reforms and credible budget con- 

solidations are neglected. Achieving public and private 

sustainability requires a more progressive attitude in 

public policy and business. These are the real future 

challenges of high sovereign debt in Europe and the 

G-20 member states. 

Figure 8: Euro Area Debt by Holders and Maturity in 2010 

2.2 Composition of Government Debt 

The composition of government debt in terms of 

maturity and currency influences both governments’ 

and investors’ costs and risks related to the rollover of 

outstanding government debt. Private and public debt 

management seeks to minimize costs and focuses 

on certain targets with respect to the sovereign bond 

market. There are several macroeconomic implications 

related to the composition of government debt: 

a) The government bond yield curve commonly 

serves as a benchmark for pricing private sector 

bonds. Higher sovereign yields distort the information 

signal and crowd out private sector borrowing; 

b) A high share of short-term debt increases the 

government’s dependence on short-term monetary 

policy rates and thus creates an incentive to increase 

Source: ECB (2011,2012).


pressure on the central bank; 

c) A high share of debt denominated in domestic 

currency protects the debt level and currency against 

exchange rate risks. 

Figure 8 depicts the composition of euro area debt 

by debt holders and residual maturity. In 2010, non- 

residents held 52% of debt in the euro area, while resi- 

dents held the remaining 48%, out of which 38% was 

held by monetary and financial institutions and the rest 

by central banks, non-financial corporations, and indi- 

viduals. The majority of euro area government debt, 

73.9%, has a maturity over one year. 

The average maturity of euro area government debt 

securities has been around six to seven years since 

2007, showing a slightly declining trend. The financial 

crisis shifted the debt maturity structure in some euro 

area countries due to governments’ liquidity risks. 


Table 6: Holder and Currency Denomination of Government Debt, 2010 

Resident Creditors Non- Currency 

Central Other Resident Denomination 

Bank MFIs Corporations Residents Creditors Euro Other 

Belgium 1.4 23.5 14.7 4.1 56.3 100.0 0.0 

Germany 0.2 31.5 9.2 10.1 49.0 98.9 1.1 

Estonia 0.0 57.0 1.1 4.4 37.9 100.0 0.0 

Ireland - - - - - - - 

Greece 3.2 23.9 0.3 3.1 69.6 98.2 1.8 

Spain 3.4 28.4 7.9 18.8 41.5 99.4 0.6 

France - - - - - 99.9 0.1 

Italy 3.6 27.0 15.6 9.1 44.6 99.8 0.2 

Cyprus 14.2 22.3 6.6 7.2 49.7 99.7 0.3 

Luxembourg 0.0 47.5 - - 30.1 100.0 0.0 

Malta 5.9 40.2 19.6 28.7 5.6 100.0 0.0 

Netherlands 0.3 18.2 10.6 2.6 68.3 92.4 7.6 

Austria 0.4 12.0 6.9 4.2 76.4 97.3 2.7 

Portugal 0.8 22.4 5.8 7.8 63.3 98.5 1.5 

Slovenia 1.0 27.7 10.1 3.5 57.7 99.8 0.2 

Slovakia 0.0 62.4 0.0 0.6 37.0 99.7 0.3 

Finland 0.0 12.5 1.2 15.2 71.1 100.0 0.0 

Euro Area 1.7 26.5 11.9 7.8 52.1 99.1 0.9 

The most visible changes were recorded in Cyprus, 

Greece, and Spain, where the share of short-term debt 

declined massively between 1995 and 2010. This sig- 

nals a reduction in rollover risk. In the first years of 

the EMU, by contrast, these countries used short-term 

debt due to easy access to the capital markets to sat- 

isfy their refinancing needs (BIS 2011). 

Finally, we discuss the holders and residual maturity of 

government debt as well as the currency denomina- 

tion by euro area countries. Table 6 summarizes the 

holders and currency denomination of government 

debt. The table with the maturities of government debt 

is relegated to the appendix (Table A1). 

Source: ECB (2011,2012). 

The analysis of the numbers in Table 6 reveals inter- 

esting patterns for certain euro area countries and 

provides valuable conclusions for investors. A com- 

parison of the five highly indebted countries reveals 

that Greece and Portugal are far more exposed to


non-resident creditors than Spain and Italy are. Greece 

has a foreign debt exposure of 69.6% and Portugal of 

63.3%. Both countries are in the top group of non-res- 

ident creditor holders in the euro area. 

Additionally, Greece and Portugal have relatively 

high shares of foreign currency debt in comparison 

to the euro area average. Admittedly, the level is not 

as high as in some other G-20 countries. However, 

both Greece and Portugal are more exposed to mar- 

ket dynamics and financial risks than other euro area 

3. IMPACT ON THE REAL AND FINANCIAL ECONOMY 

This section provides a policy-oriented analysis of the 

impact of the euro crisis on the economy. First, we anal- 

yse the economic impact of debt crises in subsection 

3.1. In subsection 3.2, we study the effect of sovereign 

yield spreads on the financial and real economy. The 

analysis is based on our own estimates and is related 

to recent research studies. Subsection 3.3 provides 

a brief discussion of tough austerity programs and 

their impact on the economy. Finally, subsection 3.4 is 

devoted to a new approach for the assessment of the 

sustainability of public finances. We demonstrate the 

usefulness of this approach for investors who consider 

investments in sovereign bond markets. This relatively 

simple but scientifically rigorous approach provides an 

overall evaluation of the sustainability of a country’s 

public finances. 

3.1 Economic Effects of Debt Crises 

There is a great deal of empirical evidence that high 

government debt hampers economic growth and dis- 

courages capital accumulation. The theoretical argu- 

ment is that high debt levels erode public finances and 

lead to expected future increases in distortionary taxa- 

tion. In addition, high and still growing public debt may 

increase nominal and real interest rates. Higher inter- 

est rates crowd out private investment, generating a 

snowball effect in which slower growth leads to even 

higher debt and higher interest expenditures, which 

are then financed by additional debt. The end result 

is a vicious cycle detrimental to economic growth and 

the sustainability of public finances. Accordingly, this 


countries. On top of this, Greece possesses one of the 

highest shares of short-term and variable interest rate 

debt with maturity over one year (Table A1), which 

greatly exposes the Greek economy to future interest 

rate decisions. Altogether, the risk exposure for Greece 

is dramatic. These patterns explain the extraordinary 

role of Greece, and illustrate that its economy is a spe- 

cial case and an exception in Europe. This statement 

does not mean that the euro crisis, including the Greek 

tragedy, is unmanageable. Instead, it means that all 

options have to be considered – and soon. 

triggers capital outflows and, in some occasions, a 

banking or exchange-rate crisis. 

Recently, several studies have offered evidence that 

debt-to-GDP levels above 80-90% impair economic 

growth (Reinhart and Rogoff, 2010; Cecchetti et al., 

2011). An analysis of Italy illustrates this for a debt-to- 

GDP level of 100%. The combination of these studies 

has led to the conclusion that, at low levels, debt is 

good. But when does debt go from good to bad? Is 

there an optimal level of government debt? 

First, it is important to note that debt is not inherently 

evil. Borrowing allows for the smoothing of consump- 

tion and income over the course of the business cycle, 

which is welfare enhancing. This improves the effi- 

ciency of capital allocation across the economy and 

across generations. Theoretically, there is the poten- 

tial in normal times for a society’s welfare to rise with 

modest debt levels. Nevertheless, the literature pro- 

vides three main channels through which sovereign 

debt affects output negatively: (1) exclusion from inter- 

national capital markets; (2) an increase in borrowing 

costs; and (3) international trade. The balance between 

positive and negative effects is merely an empirical 

question. 

The following part is an empirical investigation of this 

problem. A data sample of 24 OECD countries over the 

period of 2000 to 2010 is used. The novelty of the data- 

set is the inclusion and distinction of domestic and for- 

eign debt. With this approach we are able to analyse


the impact of foreign and domestic debt holders on 

the economy. We begin by looking at the relationship 

between debt and economic growth. Calculation of 

time-series correlation coefficients shows a statisti- 

cally significant negative relationship. Our first model 

shows that total debt-to-GDP reduces output growth 

by -0.25. The disaggregated approach allows us to 

disentagle the overall impact: Residential debt-to-GDP 

reduces output growth by -0.26, and foreign debt-to- 

GDP reduces output growth by -0.27. It is striking to 

see that a one percentage-point increase in foreign 


Figure 9: Bivariate Panel Regressions of GDP Growth and Debt Holders (in %) 

Table 7: Panel Regression of GDP Growth 

and Debt Holding 

Variable Coefficient 

Constant 4.126255*** 

(1.058854) 

FOREIGN_DEBT -0.046944*** 

(0.015499) 

RESIDENT_DEBT -0.043454* 

(0.025079) 

TOTAL_DEBT -0.003886 

(0.019561) 

Dependent: GDP growth. Panel regression. Std. errors in 

parentheses and * / ** / *** indicate statistical significants at 

10% / 5% / 1% level. 

Source: Own estimation. 

debt is associated with the largest reduction in output 

growth. This supports the hypothesis that a country 

with a high share of foreign debt holders faces more 

challenges than a country with high domestic debt 

holders. Consequently, the Greek and Portuguese debt 

problem is far more difficult to solve than the situation 

in Spain or Italy, where a relatively high proportion of 

the debt is held by residents. 

Recent evidence from the ECB’s bank-lending survey 

suggests that credit rationing increased in 2011, espe- 

cially towards non-financial corporations and house- 

holds. There are several reasons for this, including the 

higher risk of an economic downturn in the euro area, 

higher capital requirements, and further deleveraging 

needs. Interestingly, there has also been a decline in 

the demand for credit, which has been partly offset 

with more market-based financing via issuing corpo- 

rate bonds. Therefore, to evaluate the impact of this 

dynamic we estimate a regression of annual output 

growth on foreign debt-to-GDP, residential debt-to- 

GDP, and total debt-to-GDP. Figure 9 displays the 

graphical result. Statistically, all three regression mod- 

els show a significant negative relation between out- 

put growth and debt holding. This suggests that high 

debt levels are linked to lower output growth. It turns 

out that foreign debt holding has the largest negative 

impact on domestic growth (left panel). 

The second step of this empirical approach is the esti- 

mation of a multivariate time-series regression model.


The dependent variable is output growth and the inde- 

pendent variables are, once again, foreign debt-to- 

GDP, residential debt-to-GDP, and total debt-to-GDP, 

plus several control variables. By specifying time and 

cross-section fixed effects, an applicable equation was 

estimated. The results are reported in Table 7. Statis- 

tically, all coefficients display a significant negative 

effect. 

The multivariate regression confirms that foreign debt 

holding is a major obstacle to future growth. The neg- 

ative coefficient for foreign debt holding is the only 

one statistically significant at the 1% level. The other 

coefficients are significant at the 10% level or, in the 

case of total debt-to-GDP, statistically insignificant. We 

interpret the result as follows: A one percentage-point 

increase in foreign debt holding is associated with a 

reduction in subsequent output growth of 4-5% (Table 

7). Although this is quite high, we have not controlled 

for all growth factors in our regression model. There- 

fore, a suggestion for further research is an estimation 

of this effect within a comprehensive growth model 

according to Barro and Sala-i-Martin (2004). A sec- 

ond suggestion is to perform a threshold regression 

in order to identify the optimal debt level – the point at 

which debt turns from good to bad. 

It is important to note that our results are in line with 

preliminary literature in this field. Cecchetti et al. 

(2011) find that private, corporate, and household debt 

are negatively correlated with growth. Surprisingly, 

they first discover that government debt is positively 

related to growth. Admittedly, after testing all growth 

factors and crises they conclude that government debt 

is always negatively related to growth. The threshold 

for government debt is estimated to be around 85% of 

GDP, for corporate debt around 90% of GDP, and for 

household debt roughly 85% of GDP. Given the future 

challenges of demographic ageing and already-high 

tax levels in Europe, it will be difficult to stabilize or 

reduce current debt limits. Trabandt and Uhlig (2010) 

find that some European countries are already on the 

wrong side of the Laffer curve. This implies that they 

cannot generate additional revenue by further increas- 

ing capital income taxes. Consequently, fiscal policy 

will be more constrained in the future. 


There are other studies that confirm that debt crises 

may lead to significant contractions in output. For 

instance, Furceri and Zdzienicka (2011) conducted a 

study based on 154 countries from 1970 to 2008. They 

find that debt crises produce significant and long-last- 

ing output losses. On average, a debt crisis reduces 

output by about 10% after eight years. Moreover, it 

turns out that debt crises tend to be more detrimental 

than banking and currency crises. This result is similar 

to Reinhart and Rogoff (2010), who find that output is 

reduced by 1.8 percentage points when the debt-to- 

GDP ratio exceeds 70% and by more than 2.0 percent- 

age points when the debt-to-GDP ratio exceeds 90%. 

In summary, debt crises have a long-lasting and sig- 

nificant negative impact on output. Our analysis illus- 

trates that this impact is even more significant when 

foreign debt holding is high relative to residential debt 

holding. 

3.2 Economic Effects of Sovereign Spreads 

The financial and economic crisis, as well as the fail- 

ure to reverse global imbalances in a controlled way, 

have put significant pressure on public finances. On 

average, OECD countries’ deficits increased from 1% 

of GDP to 8% of GDP, while debt rose from 73% of 

GDP to 97% of GDP, between 2007 and 2010. The 

sovereign debt turmoil has been particularly severe in 

Greece, Portugal, Ireland, Spain, and Italy. In this sub- 

section we explore the major channels through which 

increasing sovereign spreads impact future output. 

A characteristic crisis of confidence in sovereigns is 

triggered by investors’ concerns about the sustain- 

ability of public finances. If the concerns are justified, 

the result is a decrease in sovereign creditworthiness 

and increase in sovereign spreads. Both effects drive 

up banks’ funding costs and impair funding and loan 

policies. Consequently, what are the triggering pro- 

cesses investors must look at to understand this tricky 

relationship? 

In theory, there are four channels through which sov- 

ereign risk affects bank funding conditions and the 

economy as a whole: 

1) Losses on sovereign holdings: Higher sovereign


yields mean losses on banks’ government bond hold- 

ings. This weakens the balance sheet, decreases cred- 

itworthiness, and affects over-the-counter derivative 

positions, the effects of which, according to anecdotal 

evidence, are sizeable (Davies 2011). 

2) Downgrading of banks: Sovereign downgrades 

often affect domestic bank ratings, raising their fund- 

ing costs and weakening their international market 

position. Only 2% of the domestic banks across seven 

euro area countries had a credit rating higher than that 

of their respective sovereign in 2010. 

3) Rescission of explicit and implicit state guaran- 

tees: The deterioration of sovereign debt reduces the 

funding benefits that banks derive from investments 

in public debt. Moreover, the political willingness of 

explicit and implicit support for banks has slightly 

changed this view. Nevertheless, more and more 

countries would like to have the banking system pay 

a fair contribution of stabilization costs via a (trans- 

action) tax. Others demand stricter financial regula- 

tion and supervision – higher core capital buffers, for 

instance – especially for systemic banks. 

4) Straitjacket of the euro area versus domestic mar- 

ket forces: There is evidence for the hypothesis that 

short-term government bond yields are related to the 

domestic deposit rates even if the ECB sets the mini- 

mum bid rate for all euro area countries. This relation- 

ship could have an impact on bank funding in certain 

countries and therefore affect the overall economy. 


Figure 10: Difference Between Short-Term and Taylor Interest Rate (in %) 

Source: own calculation with EU and ECB Data (2011,2012). 

5) Lower collateral values and higher needs for 

central bank funding: The significant downgrades of 

government bonds exclude papers from the pool of 

eligible collaterals. This affects the operations of the 

central bank, which uses sovereign debt as collateral, 

and impairs funding costs of private banks. The ECB 

has increased liquidity provisions – recently by two 

tenders of about €500 billion over three years – and 

collateralised this funding with the help of government 

bonds. This policy measure, which was meant to avoid 

a credit crunch, has reduced the funding pressure on 

private banks, but has transferred higher credit risks 

and exit costs to the ECB. 

Next, we study – using our own estimates – the impact 

of the liquidity provisions by the European Central Bank 

on sovereign debt and loan policies. The ECB plays a 

special role in the euro area because it faces a one- 

size-fits-all problem. Figure 10 shows that monetary 

policy was too accommodative from 2004 to 2008. 

Moreover, Figure 10 shows a sizeable heterogene- 

ity in the stance of monetary policy across countries 

in the euro area. This heterogeneity is a result of the 

fact that the interest rate differential – the difference 

between the key ECB interest rate and the theoreti- 

cally appropriate Taylor interest rate for each country 

– is dependent on the domestic market environment. 

A negative gap in Figure 10 illustrates that monetary 

policy is too expansive given economic conditions. 

Simply put, European monetary policy was too expan- 

sive – especially for the five problem countries of


Greece, Portugal, Ireland, Italy, and Spain – during the 

last decade. 

Since 2008, the situation – with the exception of 

Greece – has calmed down. However, macroeconomic 

stabilization has required ultra-low interest rates since 

2008. This has led to the so-called “zero lower bound” 

problem, in which interest rates fall nearly to zero and 

conventional monetary policy measures are rendered 

largely ineffective. Only unconventional measures, 

such as quantitative easing or other bond-purchasing 

programs, are effective in stimulating the economy 

and stabilizing the financial system. In theory, both 

conventional and unconventional policy measures 

increase the money supply and provide additional 

liquidity to markets. However, there is still a contro- 

versial debate in economics about the effectiveness of 

unconventional policy measures. 

The tactics vary. The Bank of Japan (BOJ) applied these 

extraordinary measures first in March 2001 because of 

the banking crisis of the 1990s. The BOJ purchased 

about ¥63 trillion of government and corporate bonds 

in 2005 to overcome deflation. Analysis of this policy 

has largely been negative because of its failure to 

accelerate recovery or significantly stimulate growth. 

After the collapse of Lehman Brothers in 2008, the 

Federal Reserve System in the United States adopted 

the same policy, causing its balance sheet to swell to 

$2.2 trillion. The Fed’s quantitative easing programs 

have mostly involved long-term government bonds 

and mortgage-backed securities. In March 2009, the 

Bank of England followed a similar policy and pur- 

chased about £198 billion of safe government bonds – 

one-sixth of the debt of the United Kingdom. The BOE 


Table 8: Comparison of Size of Quantitative Easing/Bond Purchasing Programs) 

Japan United States United Kingdom Euro Area 

2000 - 2004 2008 - 2010 2009 - 2010 2010 

In Relation to GDP (%) 4.0 10.8 13.5 0.7 

In Relation to Debt (%) 2.3 11.6 17.7 0.8 

Source: BoE, BoJ, EU, ECB, Fed, IMF (2011,2012). 

has been the most aggressive in the sheer expansion 

of its balance sheet. 

By contrast, the unconventional policy measures of 

the ECB have been less significant (Table 8). In May 

2010, during the initial stages of the sovereign debt 

crisis, the ECB initiated a bond-purchasing program in 

which it purchased about €63.5 billion of assets and 

extended long-term refinancing operations directly to 

banks. Both unconventional measures constitute a 

de facto euro zone version of quantitative easing. In 

addition, the ECB primarily bought risky government 

bonds of the troubled countries. The total volume is 

now estimated at €220 billion. Table 8 demonstrates 

that the size of liquidity provisions by the ECB was 

modest by international comparison until 2010. Thus, 

the ECB’s exit strategy – that is, the unwinding of its 

unconventional measures and shrinking of its balance 

sheet back to more normal levels – is less costly than 

for other central banks. 

Critics contend that these unconventional actions 

could fuel higher inflation and weaken the respective 

domestic currency. Whether these policy measures 

really do accelerate inflation remains unresolved. 

More dangerous in terms of inflation is the announce- 

ment by the Fed of its intention to keep its benchmark 

interest rate near zero until late 2014. This approach is 

linked to discussion of “financial repression” and con- 

stitutes an artificial manipulation of the yield curve by 

pulling down long-term bond yields. But what if the 

Fed gets it wrong? It would certainly not be the first 

time a central bank got it wrong (Barnett 2012). 

Next, we estimate the impact of sovereign yields on


Figure 11: Sovereign Risk Prima (in basis 

points) Versus Debt-to-GDP (in %) in 

Selected Euro Area Countries (2008 to 

2010) 

loan policy while controlling for monetary policy. Con- 

sistent with the literature, we find nonlinearities in 

the relationship between sovereign risk and govern- 

ment debt (Figure 11). In addition, our result confirms 

the hypothesis that loan policy is more constrained 

towards both non-financial and financial corporations. 

The impact on households is similar, but insignificant 

(Figure 2A – Appendix). 

Moreover, a comprehensive time-series regression 

confirms the negative impact on output of high sov- 

ereign spreads. By estimating a VAR model with inno- 

vatively gathered flow-of-funds statistics for the euro 

area, we find evidence that an unexpected policy tight- 

ening significantly cuts firm and household demand 

for bank loans. However, firms partially replace a 

monetary contraction with inter-company loans, while 

households increase precautionary savings. In the end, 

both effects slow economic activity and credit dynam- 

ics while worsening budget deficits. We find that loan 

policy matters most to the corporate sector due to the 

pivotal role of business firms in the economy. 

There are numerous avenues for further research. We 

suggest a panel data set for all euro area countries in 

order to identify existing differences in loan policies 

across euro area member states. Furthermore, the 


inclusion of more control variables, such as open mar- 

ket operations by the ECB, changes in the minimum 

bid rate, or downgrades, might improve the robust- 

ness of the results. 

3.3 Economic Effects of Austerity Measures 

The austerity hypothesis that slashing budget deficits 

will stimulate economic growth is currently in vogue 

in Europe. As a result, the last several years have seen 

considerable research in this field. Alesina and Perotti 

(1996) argue that fiscal consolidation is expansionary 

if implemented through spending cuts. This sounds 

contrary to conventional wisdom but is based on rig- 

orous empirical research. The following subsection 

briefly summarizes some stylized facts of austerity 

programs and their impact on the economy. There are 

three conclusions: 

* Fiscal adjustments on the spending side are more 

likely to lead to a permanent stabilisation of the budget 

than revenue increases; 

* Adjustments on the spending side have lower costs 

in terms of lost output; 

* Fiscal adjustments on the spending side are not fol- 

lowed by an economic downturn due to the so-called 

confidence effect on consumers and investors. Cred- 

ible spending-side consolidation does work. 

The quantitative impact of fiscal consolidation via 

higher revenues (i.e. higher taxes) is estimated by 

Romer and Romer (2007). They find that a 1% higher 

tax rate reduces output by about 3% in the follow- 

ing three years. On the other side of the ledger, the 

seminal paper by Blanchard and Perotti (2002) finds 

that spending-side consolidation increases output and 

consumption. For OECD countries, the authors also 

show that the effect of revenue-side consolidation is 

to reduce output in the first three quarters by an aver- 

age of 0.6 percentage points. 

It is important to understand that raising taxes has neg- 

ative supply-side effects on labour costs and invest- 

ments. On the contrary, these supply side-effects do


Table 9: Sustainability Regulation for Germany 

and United States (US) 

Variable Germany US 

Constant -3.7505* 0.0509*** 

not apply to spending cuts, which imply lower future 

taxes. Almost all successful supply-side consolida- 

tion episodes led to lower interest rates and were 

supported by wage moderation, which played a key 

role in ensuring competitiveness. There is also evi- 

dence that countries that depreciate their currencies 

to regain competitiveness are unable to do so without 

wage restraints. In conclusion, whether a country is 

inside or outside a monetary union, wage moderation 

is always needed in order to regain competitiveness 

and to consolidate the public budget. The combina- 

tion of currency depreciation and wage restraint is the 

most efficient and fastest way to get back on track. 

3.4 Public Debt Sustainability: Evaluation of Inves- 

tors’ Decision-Making 

(1.9409) (0.0151) 

Debt-to-GDP 0.0610** -0.0017*** 

(0.0265) (0.0002) 

GVAR -1.3354*** -0.01433** 

(0.0793) (0.0049) 

YVAR -22.4822*** -0.0530 

(4.2545) (0.2181) 

Adj. R-squared 0.8921 0.9298 

F-statistic 42.3587 71.6486 

Dependent: GDP growth. Primary deficit. Regression, Newy- 

West t-values controlled for autocorrelation and heteroskedasty. 

Std. errors in parentheses and * / ** / *** indicate statistical 

significants at 10% / 5% / 1% level. 

Source: Own estimation. 

Both liquidity and solvency aspects are linked to the 

analysis of the sustainability of public finances. Debt 

sustainability generally refers to the ability of the gov- 

ernment to manage its public finances by servicing its 

debt obligations while meeting the provisions of goods 

and services for society, both now and in the future. 


A simple starting point for the assessment of sustain- 

ability is the evolution of the government debt-to-GDP 

ratio. More in-depth studies also consider implicit gov- 

ernment debt and liquidity dimensions, i.e. whether the 

government is able to rollover its maturing debt obliga- 

tions in an orderly manner. This subsection exemplifies 

the assessment of sustainability for the United States 

and Germany. We argue that this approach is helpful in 

evaluating the sustainability of sovereign debt. More- 

over, it is easily applicable to investors’ decision-mak- 

ing. The scientific underpinning and technical detail of 

this method is based on a paper by Herzog (2010). 8 In 

this case we use data from 1980 to 2010 for govern- 

ment expenditures, deficits, primary deficits, debt, and 

output. 

The most effective test of sustainability of public 

finances is a positive response of primary surpluses 

to the debt-to-GDP ratio while controlling for govern- 

ment spending (GVAR) and the business cycle (YVAR). 

The regression results are reported in Table 9. Our 

estimates are robust for all regressions. 9 We find that 

German public finances are sustainable with a posi- 

tive debt-to-GDP coefficient of 0.061. This coefficient 

is statistically significant at the 5% level. In contrast, 

U.S. public finances are currently unsustainable with a 

negative debt-to-GDP coefficient of -0.001. This num- 

ber is statistically significant at the 1% level. 

Why is a positive response of primary surpluses to 

the debt-to-GDP ratio an indicator of sustainability? 

The positive relationship can be derived from a rigor- 

ous general equilibrium model, beyond the scope of 

this white paper. Here we explain this issue by a more 

intuitive approach. A necessary and sufficient condi- 

tion for unsustainable finances is the following empiri- 

cal relationship: Increasing primary deficits (negative 

number) triggers higher debt accumulation (positive 

number). In other words, this is a negative relation 

because the deficit becomes more negative and the 

debt becomes more positive. Thus, a negative relation 

indicates unsustainable finances. On the contrary, sus- 

tainable finances require a positive relationship, i.e. the 

higher the debt, the higher the primary surpluses or 

the lower the primary deficits.


For Germany we see this positive relationship in the 

debt-to-GDP coefficient in our regression. For the 

United States we find a significant negative relation- 

ship. This finding points to an unsound fiscal policy 

in the U.S. Our calculation has immediate and very 

valuable implications, because it provides a simple but 

useful assessment of the soundness of public finances 

across countries. Investors now have a relatively fast 

and applicable procedure for evaluating the sustain- 

ability of sovereign debt. 

The unsustainable situation in the United States is a 

huge policy challenge going forward. This challenge 

is amplified by the widening deficit and massive debt 

accumulation of the last several years, the weak eco- 

nomic outlook, accelerating health-care spending, 

and persistently elevated unemployment rates. Given 

that the U.S. also faces a large current account deficit 

4. POLICY CONCLUSIONS & OUTLOOK 

This white paper addresses the question of whether 

we face a pure euro crisis or a sovereign debt crisis 

and what the implications for the macroeconomy are. 

Fortunately, the euro has not lost confidence despite 

the challenging structural problems in the EMU. But 

how can a currency gain or lose confidence? Keep in 

mind that a currency is a confidence trick: Its value 

depends entirely on the belief that it has value. This 

belief, in turn, strongly depends on the monetary and 

fiscal fundamentals of a country or a group of countries 

in a monetary union. Since the European Central Bank 

is entirely independent, the euro crisis was mainly trig- 

gered by European and national policies. Thus, the 

euro crisis was caused by unsound fiscal policies and 

an unsuitable institutional setup within the EMU. The 

resulting crisis of confidence can be attributed to this 

unique setup. 

The re-design of this institutional framework requires 

both the strengthening of rules and increased eco- 

nomic integration. As discussed above, there are two 

long-run options: either more centralization or more 

decentralization. To date, the monetary union has 


and an ageing population, the debt problem could 

exacerbate in the future. By comparison, Germany is 

in a sound position. At the moment, the U.S. has the 

advantage that the dollar is still the world’s reserve 

currency, which allows it to borrow at reduces rates, 

and the demographic changes it faces are slower than 

in Europe. 

An interesting question for further research is the 

assessment of sustainability in all European coun- 

tries or the G-20. A second research hypothesis for 

the future is the question of nonlinear effects of the 

debt-to-GDP ratio and the impact of the 60% thresh- 

old. Resolution of these issues would offer important 

insights for investors. We recommend – as a lesson of 

the sovereign debt crisis – more research in this field 

to support the decision-making process of long-run 

financial investments in sovereign bond markets. 

been based on a decentralized market approach, but 

with a no-bailout clause that lacked credibility and a 

weak enforcement mechanism within the Stability and 

Growth Pact. Interestingly, the treaty also contains 

an implicit “no exit clause,” which creates the wrong 

incentives in such an environment. This arrangement 

led market participants to believe that all countries in 

the EMU are indistinguishable and that the project is 

irrevocable. However, this claim is wrong in an effec- 

tive decentralized approach. EMU fiscal policy was and 

still is made at the national level and therefore exposed 

to different domestic shocks and risks. Investors might 

learn that, despite a common currency, sovereign risks 

vary from country to country. There exist two options 

for circumventing this perception in the long run. The 

centralization approach establishes a transfer union via 

a permanent transfer of sovereignty from the national 

to the European level and a joint financing of public 

debt. The decentralized approach, on the other hand, 

is based on effective rules, market forces, and either a 

systematic exit clause or a temporary transfer of sov- 

ereignty in the case of unsound policy. Political com- 

mitment to one of the long-run options is needed to


stabilize the monetary union now and in the future. 

There is no doubt that the new fiscal compact is a step 

in the right direction, though past experience casts a 

skeptical eye on this approach. Nonetheless, it might 

be sufficient to buy time and bring back investors’ con- 

fidence in the euro area. Yet the long run remains chal- 

lenging, especially when reform pressures decline as 

market conditions improve. The litmus test will be the 

ongoing enhancement and rigorous implementation 


of the fiscal compact. Tackling the root causes is of 

particular interest in case of a crisis of confidence. 

A simple treatment with Keynesian stimulus policy, 

which is reasonable and appropriate in the face of 

demand shocks, will trigger the wrong incentives dur- 

ing such crises. Certainly there is no simple solution to 

the euro crisis, but muddling through without a clear 

direction is fraught with growing dangers – and ulti- 

mately doomed to fail.


References 

Alesina, A. and R. Perotti (1996), “Fiscal Discipline and 

the Budget Process”, American Economic Review, 

Vol. 86, No. 2, pp. 401-407. 

Anginer, D. and A. Demirguc-Kunt (2011), Has the 

Global Banking System Become More Fragile over 

Time?, Policy Research Working Paper, No. 5849, 

World Bank. 

Attinasi, M.G. et al. (2009), What Explains the Surge 

in Euro Area Sovereign Spreads during the Financial 

Crisis of 2007-08?, ECB Working Paper, No. 1131, 

Frankfurt. 

Barnett, W.A. (2012), Getting It Wrong – How Faulty 

Monetary Statistics Undermine the Fed, the Financial 

System, and the Economy, MIT Press. 

Barro, R. and X. Sala-i-Martin (2004), Economic 

Growth, MIT Press. 

BIS (2011), Interactions of sovereign debt manage- 

ment with monetary conditions and financial stability, 

Report, No. 42. 

Blanchard, O. and R. Perotti (2002), “An Empirical 

Characterization of the Dynamic Effects of Changes in 

Government Spending and Taxes on Output”, Quar- 

terly Journal of Economics, Vol. 11, pp. 1329-1368. 

Cecchetti, S. et al. (2011), The Future of Public Debt, 

in S. Gokarn (ed.), Challenges to central banking in the 

context of the financial crisis, pp. 183-217. 

Davies, M. (2011), “The rise of sovereign credit risk: 

implications for financial stability”, BIS Quarterly 

Review, No. 09, pp. 59-70. 

Elekdag, S. and Y. Wu (2011), Rapid Credit Growth: 

Boon or Boom-Bust?, IMF Working Paper, No. 241, 

Washington. 

Furceri, D. and A. Zdzienicka, (2011), How Costly 

Are Debt Crises?, IMF Working Paper, No. 280, 

Washington. 


Herzog, B. (2010), “Anwendung des Nachhaltigkeit- 

sansatzes von Bohn zur Etablierung eines Frühindika- 

tors in den öffentlichen Haushalten“, Kredit und Kapi- 

tal, Vol. 43, No. 2, pp. 183-206. 

Herzog, B. (2011), “Wohin steuert die europäische 

Wirtschafts- und Währungsunion?“, Zeitschrift 

Positionen, Vol. 19, pp. 7-24, Berlin, ISBN 

978-3-942775-40-3. 

Herzog, B. (2012), “EMU at Crossroads”, Quarterly 

Journal on European Issues, CESifo Forum, No. 

4/2011, pp. 23–29. 

Mink, R. et al. (2008), Reflecting Pensions in National 

Accounts Work of the Eurostat/ECB Task Force, NBER 

Working Paper, No. 15815. 

Reinhart, C.M. and K. Rogoff (2010), “Growth in time 

of debt”, American Economic Review, No. 100, pp. 

573-578. 

Romer, C. and D. Romer (2010), “The Macroeco- 

nomic Effects of Tax Changes: Estimates Based on a 

New Measure of Fiscal Shocks”, American Economic 

Review, Vol. 100, No. 3, pp. 763-801. 

Trabandt. M. and H. Uhlig (2010), How far are we from 

the slippery slope?, The Laffer curve revisited, ECB 

Working Paper Series, No. 1174.


Appendix 

Source: IMF (2011,2012). 


(Positive numbers for surplus countries and negative for deficit countries) 

Figure 1A: Current Account in Billions of USD of Major Countries in 2010



Figure 2A: Spreads on Sector-Specific Loan Policies, in log (y-axes)


Table A1: Residual Maturity of Government Debt, 2010 

Up to 1 year Over 1 and up to 5 years Over 5 years 


variable variable 

interest rates interest rates 

Belgium 24.0 35.5 0.0 40.5 0.0 

Germany 28.1 35.5 - 36.5 - 

Estonia 8.3 32.9 0.0 58.8 0.0 

Ireland - - - - - 

Greece 10.2 41.5 13.8 48.3 15.3 

Spain 21.5 35.9 0.0 42.6 0.0 

France 33.3 31.7 0.2 35.0 0.1 

Italy 25.2 30.4 5.4 44.5 4.2 

Cyprus 10.6 44.9 0.0 44.5 10.2 

Luxembourg 9.0 - - - - 

Malta 13.7 45.1 1.6 41.2 0.0 

Netherlands 29.6 31.7 0.0 38.7 0.0 

Austria 8.8 34.2 0.7 57.0 0.6 

Portugal 29.5 28.5 1.3 41.9 0.2 

Slovenia 8.8 34.1 3.8 57.1 0.8 

Slovakia 13.8 43.0 7.8 43.3 0.1 

Finland 24.0 34.9 12.8 41.1 13.7 

Euro Area 26.1 33.6 2.9 40.3 2.9 

Source: ECB (2011,2012).


Endnotes 

1. Private deficits are calculated as the current account 

minus the public balance. Thus, the number reports 

the private deficit holdings of the selected countries. 

2. I am preparing another DWS white paper about 

demographic challenges and their impact on the real 

and financial economy. This study contains a more 

detailed analysis of those implications and will be 

forthcoming in the second half of 2012. 

3. Cf Beise (2012). He is arguing that the crisis of con- 

fidence diffuses slowly towards the heart of Europe – 

the euro currency. Source: Süddeutsche Zeitung, 10 

January 2012. 

4. Cf Szalay (2012). She is arguing that the euro cur- 

rency is more prepared for the future challenges than 

the U.S. Europe is tackling the structural problems 

now, while the U.S. is shifting its problems into the 

future. 

5. Definition of government debt is always based 

on ESA debt (ESA stands for European System of 

Accounts 2010). ESA defines government debt as 

a stock variable which covers all explicit liabilities at 

market value, excluding equity. Therefore, the level of 

ESA debt is affected by changes in market yields. 

6. For our debt comparison we apply the “EDP debt” 

definition used in Europe. EDP stands for Excessive 

Debt Procedure. This definition covers government 

liabilities such as currency and deposits, securities 

other than shares (excluding financial derivatives), and 

loans. 

7. Net debt takes into account prices and marketability 

of government assets. However, this leads to potential 

biases in periods of market turbulences and compli- 

cates the compilation, whereas gross debt remains 

a more robust indicator and is better used for simple 

comparisons without the necessary adjustment we 

have to do under the net debt definition. 

8. Our data displays severe heteroskedasticity which is 

why we use Newy-West adjusted standard errors and 

tackle the stationarity problem by calculating the gaps 


of current to long-run trends. The long-run trends are 

estimated with a Hodrick-Prescott (HP) filter. 

9. We also estimated time-series regressions from 

1919 to 2011 and 1960 to 2011 for the U.S. We 

find a robust negative relationship between primary 

deficit and debt-to-GDP while controlling for govern- 

ment spending and the business cycle according to 

the Bohn approach. All results point to unsustainable 

public finances in the U.S. For Germany we have data 

restrictions until 1995 due to the re-unification process 

in 1990 and the new public finance budget rules in 

1995.

32 

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