To bail out or not to bail out? Crisis politics, credibility, and default risk in the Eurozone

Abstract

We examine the impact of signals regarding the Eurozone’s bail-out commitment on government bond spreads in the Eurozone’s periphery, analysing the effect of positive, negative and mixed statements and decisions by the EU, the ECB and Germany. We construct a dataset of relevant events, and estimate their effects using distributed lag models, providing a number of robustness checks. Our main argument is that investors react to statements from credible actors, but largely ignore statements from less-credible actors, awaiting actual decisions. Accordingly, positive statements from the ECB have clear effects, while those from Germany and the EU do not. Furthermore, ECB decisions appear to be anticipated and thus have no short-term effects, while we find clear effects of positive decisions by Germany and the EU.

Capacity, Willingness, and Sovereign Default Risk: Reassuring the Market in Times of Crisis

“…First, we argue it is important to distinguish between statements and decisions, and thus also to consider when markets should react to either type of signal. In line with Bølstad and Elhardt (), we argue that statements only carry useful information insofar as they are credible and allow the anticipation of later decisions (see also Bechtel and Schneider, ). Political actors generally lack such credibility, as they have strategic incentives to please both markets and domestic constituencies.…”

“…In contrast, the technocratic ECB is far more credible, and therefore able to use statements as a tool for signaling its intentions – as in the case of forward guidance. The ECB's statements have thus been found to matter more than its decisions (Bølstad and Elhardt, ). Accordingly, we refer to key signals for the different actors: decisions for political actors (both at the national and European level), and statements for the ECB.…”

Two-level games and market constraints on politics in Europe

“…Of course, there is much debate about exactly what markets monitor, how clear their signals are, and how wide the constraints on policy are. The much smaller literature on EU institutions and markets focuses on how variations in the credibility of institutions and actors influence their ability to assuage markets (Bechtel and Schneider, 2010;Goldbach and Fahrholz, 2011;Smeets and Zimmermann, 2013;Bølstad and Elhardt, 2015).…”

“…The literature on national politics and financial markets shows that investors do monitor national politics; market movements can send signals to national politics; and these signals can serve as a substantial constraint on national economic policy (Bernhard and Leblang, 2006;McMenamin et al, 2015;Mosley, 2003;Sattler, 2013).Of course, there is much debate about exactly what markets monitor, how clear their signals are and how wide the constraints on policy are. The much smaller literature on EU institutions and markets focuses on how variations in the credibility of institutions and actors influence their ability to assuage markets (Bechtel and Schneider, 2010;Bølstad and Elhardt, 2015;Goldbach and Fahrholz, 2011;Smeets and Zimmermann, 2013).…”

The Political Economy of Financial Markets

“…Using more encompassing data and new methods, Tetlock (2007) shows that media pessimism helps predict market trading volume and negative stock market returns. Important examples of sources of policy signals are media outlets (e.g., Bechtel & Schneider, 2010;Beetsma et al, 2013;Wilf, 2016) and politicians' and central bankers' statements (e.g., Kohn & Sack, 2003;Ehrmann & Fratzscher, 2007A;Goldbach & Fahrholz, 2011;Falagiarda & Gregori, 2015;Bølstad & Elhardt, 2015). Yet, there is still much work to do in this direction.…”