The sovereign debt crisis: Structural reforms and country risk

by Miguel Cardoso and Rafael Doménech

VOX
13 December 2010

Are concerns over the sustainability of sovereign debt in Europe justified? This column presents data covering 16 developed countries including Greece, Italy, Portugal, and Spain. It shows that these countries have worryingly low levels of human capital and income per head and argues that policymakers in these countries should press ahead with reforms to reassure investors of their future growth potential.

Fiscal policies have been at the centre of the policy debate throughout the crisis – and with good reason. When activity in most advanced economies was falling sharply, experts and analysts, international institutions, and the public asked for active discretionary fiscal stimulus. At that, time reducing private-sector uncertainty was crucial to reducing tensions in financial markets. Later, once most economies had escaped from recession, the attention of financial markets focused on the sustainability of the newly burdened public finances. As a consequence of these subsequent financial tensions, Europe has faced two episodes of sovereign debt crises. In May it was Greece; in November it was Ireland.

During this period of sovereign debt crises, financial markets have been putting more emphasis not only in government capacities for achieving fiscal consolidation, but also in the ability of their economies to sustain high GDP growth rates in the medium term without the support of fiscal and monetary policies. Thus, the different risk perceptions of advanced economies by financial markets reflect a combination of differences in terms of public budget deficit and debt levels (particularly held by foreigners) and expectations of future growth. But this combination of determinants of risk premia should not be surprising at all – the sustainability of the public debt to GDP ratio depends simultaneously on the ability to reduce public deficits and on the growth prospects of each country, which also depend on the structural capacity of their economies.

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