Thursday, October 3, 2013

2/10/2013: Euro area sovereign crisis: predictable and reasonably priced?



  • Can a model-based credit ratings system be used to predict future fiscal distress? Answer seems to be: yes.
  • And have the fiscal downgrades of the euro area peripheral states been predictable in advance? Answer seems to be: yes.
  • In other words, are the downgrades warranted by the actual pre-crisis dynamics in the economies? Answer seems to be: yes.
  • Lastly, were there useful signals of stress build up that could have been considered by the policymakers prior to the onset of the crisis to alleviate or prevent the collapse of euro area peripherals? Answer seems to be: yes.


A new paper from CEPR (DP9665) titled "Sovereign credit ratings in the European Union: a model-based fiscal analysis" and authored by Vito Polito and Michael R. Wickens (September 2013: http://www.cepr.org/pubs/dps/DP9665) presents "a model-based measure of sovereign credit ratings derived solely from the fiscal position of a country: a forecast of its future debt liabilities, and its potential to use tax policy to repay these." [emphasis is mine]

The authors "use this measure to calculate credit ratings for fourteen European countries over the period 1995-2012. This measure identifies a European sovereign debt crisis almost two years before the official ratings of the credit rating agencies."

Ouch!

Now, the fourteen European (EU14) countries in the model-based calculations are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, Spain, Sweden and the U.K.

So the main findings are: "…The model-based credit ratings:

  1. Anticipate the downgrades of Ireland, Spain, Portugal and the U.K. that occurred from the end of the 2010s; 
  2. Downgrade Greece to the lowest rating (coinciding with its highest default probability) from at least mid 2000; 
  3. Suggest that the Italian sovereign credit rating has been overstated. 
  4. For all other countries, the model-based credit ratings are similar, but not identical, to the credit ratings provided by the CRAs 

"An implication of these results is that the cross-section distribution of the model-based sovereign credit rating is no longer concentrated within the investment grade prior 2010 and it starts changing significantly from 2008. This suggests that a model-based credit rating would have identified and signalled to market participants signs of the impending European sovereign debt crisis well before 2010, when the CRAs first reacted to the crisis."

And the kicker: "A by-product of the methodology proposed in this paper is the quantification of a country's debt limit (measured as its maximum borrowing capacity) and how this changes over time. The numerical analysis suggests that for most EU14 countries the scope for increasing borrowing capacity by increasing taxation is limited as actual tax revenues are similar to tax revenues maximized with respect to tax rates."

In other words, we've run out of the road for taxing our way out of the crisis.

"Our findings suggest that EU14 countries are more likely to be able to raise debt limits and achieve fiscal consolidation by reducing their expenditures than by increasing taxes."

Any wonder? Ok, check out the first link here: http://trueeconomics.blogspot.ie/2013/10/2102013-low-tax-free-market-economy.html
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