Part I: A Background Study of the Eurozone
Part 2: The episode of the debt crisis: an Empirical study
IV. Results
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government gross debt to GDP ratio, the private sector credit flow to GDP ratio, the percentage change of the nominal unit labor cost and the net external debt to GDP ratio. Ф in equation (1) is the cumulative standard normal distribution at z = ᵝ0 + ᵝ1 X1 + ᵝ2 X2 + ᵝ3
X3 + ᵝ4 X4 + ᵝ5 X5.
IV. Results
Table 3.2 presents the results of our analysis. With a panel dataset, we are unable to run a lag test to determine the ideal numbers of lags to use. Thus, we are left with the try and error option. To avoid the issue of serial correlation, we would not have more than one lag of the same variable in any model. We know for sure that our independent variables’ effect on the probability to experience financial distress in the Eurozone does not happen during the same period. Thus, the ideal model might be composed of different lags but with each variable represented by only one lag.
We started by running the regression for lags 1 of all the variables: model (1). The current account lag 1 has the expected sign and is significant. Private sector credit boom is significant but does not have the expected sign. This is explained by the fact that after the start of the crisis the relationship between private credit boom and the bond yield spread was negative: the private credit was collapsing while the spread was surging. This situation suggests that we do not have the ideal lag for private credit boom. We need to go further in the past to find our expected relationship. Besides the current account, net external debt exhibits an expected sign and is significant at 10%. In model (1) the remaining variables - government gross debt and labor cost - are not significant either (with the labor cost not of expected sign).
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In model 2, we replaced the lags 1 of the private sector credit boom and labor cost by their lags 2 variables. The private credit boom sign is still unexpected and its coefficient significant (however weak as compared to model 1) but labor cost coefficient has now an expected sign. More importantly, we obtain a significant coefficient for government gross debt.
In model 3, we replaced private credit boom lag 2 by its lag 3 variable, its coefficient became positive and significant. The coefficient of labor cost turned negative again, however not significant. These changes point out an issue of imperfect multi-collinearity among the independent variables. Model (3) has the highest number of significant variables with expected sign. Even though we were able to increase the number of significant variables, the explanatory power of our models was decreasing: from model 1 to 2 and 3, the pseudo R2 is decreasing.
In model (4) we replaced current account lag 1 by it lag 3 value, the coefficient of private credit boom turned negative but remained not significant. The nominal unit labor cost has a negative coefficient (contradictory to our initial hypothesis) and is significant at 10%.
Similar to what we have seen with private sector credit boom in model (1), we argue that in the model we do not have the ideal lag for labor cost and there a multi-collinearity between the labor-cost and the other independent variables. The explanative power of model (4) is greater than that of the other models. This model is the best so far.
From this analysis, we retain three things. First, the probability to experience financial distress in the Eurozone is greater for countries that have accumulated a current account deficit and high government gross debt as witnessed by our regression outputs. Second, the impact of private sector credit boom on financial distress appears to be weak at first, but
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becomes more important when we consider higher lag variables. Third, even though net external debt and private sector credit boom have not exhibited high significance, they are implicitly taken into account throughout respectively current account balance and government gross debt – the imperfect multicollinearity among the independent variables.
As a matter of fact, there is a negative correlation between the current account balance and the external debt: the higher the current account balance, the lower the external debt. In addition, referring to the literature on the Eurozone debt crisis, we also know that at some point during the crisis the governments of countries in crisis bought up the private debt to protect their economies. Therefore, we can safely rely on the current account and government gross debt impact on Eurozone financial distress to draw conclusions and provide policy recommendations.
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Table 3: Regression output
Models (1) (2) (3) (4)
Current account balance % of GDP (-1) -.1171696 (-4.38)***
-.0775107 (-3.35)***
-.0432285 (-1.99)**
Current account balance % GDP (-3) -.1361261
(-5.15)***
Government gross debt % of GDP (-1) .0047579 (1.36)
Private sector credit flow % of GDP (-1) -.0753788 (-3.32)***
Private sector credit flow % of GDP (-2) -.0396838
(-2.23)**
Private sector credit flow % of GDP (-3) .0198518
(1.67)*
-.0030685 (-0.15) Nominal unit labor cost based on hours worked,
percentage change on the previous period (-1)
-.0314458 (-0.89) Nominal unit labor cost based on hours worked, percentage change on the previous period (-2)
.0166651
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Summary
The optimal currency area theory implies that countries forming a monetary union should have a common fiscal authority to intervene and regulate in case of asymmetric macroeconomic shocks. However the Eurozone is a monetary union with no fiscal union thus no common fiscal authority. The fact that only the monetary policy is conducted at the union level and all the remaining macroeconomics policies operates at national level leads to an exaggeration of the booms in booming countries and an even higher recession in busting countries. Additionally, as far as the Optimal Currency Areas theory criteria are concerned, the Eurozone indicators are far below the ideal.
The financial integration resulting from the establishment of the Euro has increased the vulnerability of the periphery Eurozone countries. It was expected that financial integration would increase investment and build up exports. More importantly, there was a belief that the monetary union cannot be subject to balance of payment crisis and payments imbalance in monetary unions are not issues. However, the capital that flew in to the European periphery countries was directed toward non-tradable sector. Sooner, the debt became unsustainable because no counterpart in term of export capacity was not being generated.
Furthermore, the financial integration played a substantial role in the aggravation of the crisis. By its means, countries experienced a disastrous sudden stop in capital inflows.
In light of the debt crisis, the Eurozone established the Outright Monetary Transaction (OMT), the European Banking Authority (EBA), and the European Financial Stability Facility later on replaced by the European Stability Mechanism. While the EFSF/ESM are sorts of fiscal transfer mechanism to support the countries in crisis, the OMT attribute the role of lender of last resort to the European Central Bank and the EBA is a sort of banking
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union. Despite the fact that these mechanisms have received many critics from eminent economists, it shows that a monetary union should be accompanied by even a tiny bit of fiscal union and a banking union.
Our quantitative analysis suggest that the probability to experience financial distress in the Eurozone is greater for countries that have accumulated large current account deficit and public debt. Even though we found that, the relationship is weak for private sector credit boom and net external debt these two variables intrinsically influence the Eurozone countries financial distress as well. In fact, the external debt is negatively correlated to the current account balance and private sector credit boom is correlated with government gross debt: throughout the automatic stabilizer of the government budget mechanism, the enormous private debt has been transferred to the public during the episode of the Eurozone debt crisis
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