A ‘crowding out’ theory of the eurozone crisis

A ‘crowding out’ theory of the eurozone crisis

Creditor discrimination and crowding-out effects

In Broner, Erce, Martin and Ventura (2014), we propose a theory to interpret these events. The idea rests on three key assumptions:

  • Governments sometimes discriminate towards domestic creditors;
  • Public debts trade in secondary markets; and
  • Financial frictions limit private borrowing.

Inside our model, creditor discrimination is introduced as an increased possibility of default on foreign than on domestic creditors. Because of this, when the likelihood of default increases, debt becomes relatively more appealing to domestic residents. But discrimination could possibly be broadly interpreted to add various regulations and moral suasion that raise the incentives of domestic finance institutions to get their government’s debt in turbulent times. Secondary markets make sure that the debt is assigned to whoever values it most, i.e. domestic and foreign creditors can’t be segmented.

The severe nature of private financial frictions is vital to determine the aftereffect of these public debt holdings on investment. At one extreme, if private credit markets worked perfectly, purchases of public debt by domestic creditors could possibly be fully financed through foreign borrowing and could have no influence on investment. Instead, we assume that domestic residents face financial frictions and may only pledge to creditors a fraction of the returns from their public debt holdings or physical investments. Because of this, purchases of sovereign debt by domestic creditors displace productive investment. This crowding-out effect creates crucial interactions between default risk, public debt holdings, and investment and growth.

The idea has important implications that resonate well with European events. Consider, for example, the model’s predictions regarding the consequences of an instant build-up of debt. How does such a build-up affect the domestic economy?

Based on the theory, such a build-up includes a negative effect on investment and growth when it’s accompanied by a rise in sovereign spreads. The reason being the upsurge in spreads induces domestic debt repurchases that displace productive investment and decelerate growth. This effect happens the following. As spreads on sovereign bonds increase, financially constrained domestic agents need to choose between buying higher yielding public bonds, that they can acquire from foreign investors in the secondary market, and financing private investment. Insofar as private investment is suffering from decreasing returns to scale, a rise in spreads will thus result in lower investment. That is undesirable because domestic investors are employing resources to repurchase public debt precisely when investment is most needed. Indeed, we show that effect could possibly be so strong concerning abort the recovery and permanently trap the economy in a low-output equilibrium. This result seems in keeping with the actual fact that spreads are higher in the European periphery than in the core despite the fact that the degrees of public debt are similar in both sets of countries.

The relevant question appears to be when will a debt build-up be accompanied by a rise in sovereign spreads? The idea shows that that is more likely to occur in economies with weak institutions. Weak institutions may take the proper execution of both strong discrimination against foreigners, and a higher tendency for governments to do something opportunistically. Moreover, weak institutions open the entranceway to self-fulfilling crises driven by negative shifts in investor sentiment. We show that it’s possible to simultaneously have:

  • A good equilibrium where markets expect the likelihood of default to be low, sovereign spreads remain low, there are no domestic debt repurchases, investment and growth are high, and the likelihood of default is definitely low; and
  • A pessimistic equilibrium where the market expects the likelihood of default to be high, sovereign spreads increase, there are domestic debt repurchases, the resulting crowding out leads to low investment and growth, and the likelihood of default is definitely high.

Based on the theory, reducing public debt through fiscal austerity and strengthening institutions might help the economy avoid the chance of such self-fulfilling crises. The idea also shows that a global lender of final resort could be particularly useful in this context.

Finally, the idea also sheds light on the need for owned by an economic union. The main element assumption we make here’s that there surely is less creditor discrimination against countries in the union than against countries beyond your union. Due to this, demand for public debt from poorer union members is relatively high among richer union members. Because of this, crowding-out effects could be ‘exported’ within the union, from poor to rich countries. But any perceived upsurge in the likelihood of a union breakup will certainly reduce this effect, resulting in sharp reversals in the holdings of debt within the union. Put on the Eurozone, these email address details are consistent with both large build-up of periphery-debt holdings at the core prior to the crisis and the shift with debt holdings through the crisis. Yet another implication of the idea is that union members with strong institutions can intermediate between your international financial market and the union’s distressed members. This intermediation reduces crowding out within the union and may raise growth and welfare in every of its members. Interestingly, the loans designed to the periphery by the European Financial Stability Facility and the European Stability Mechanism could be interpreted in this light. By replacing domestic private creditors with foreign creditors, the Facility and the Mechanism might help redirect credit towards productive investment in the periphery while, as well, it generates profits that may benefit countries at the core.

Disclaimer: The views expressed in this column are those of the authors, and really should not be reported as representing the views of the lender of Spain or the European Stability Mechanism (ESM).


Merler, S, and J Pisani-Ferry (2012), “Who’s afraid of sovereign bonds?”, Bruegel Policy Contribution 2012/02.

Brutti, F, and P Sauré (2013), “Repatriation of debt in the euro crisis: Evidence for the secondary market theory”, mimeo

Lane, P (2012), “The European sovereign debt crisis”, Journal of Economic Perspectives 26, 49-68.

Shambaugh, J (2012), “The euro’s three crises”, Brookings Papers on Economic Activity Spring 2012, 157-211

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