The European debt crisis: Defaults and market equilibrium

During the last two years, Europe has been facing a debt crisis, and Greece has been at its center. In response to the crisis, drastic actions have been taken, including the halving of Greek debt. Policy makers acted because interest rates for sovereign debt increased dramatically. High interest rates imply that default is likely due to economic conditions. High interest rates also increase the cost of borrowing and thus cause default to be likely. In equilibrium markets, economic conditions are used by the market participants to determine default risk and interest rates, and these statements are mutually compatible. If there is a departure from equilibrium, increasing interest rates may contribute to—rather than be caused by—default risk. Here we build a quantitative equilibrium model of sovereign default risk that, for the first time, is able to determine if markets are consistently set by economic conditions. We show that over a period of more than ten years from 2001 to 2012, the annually-averaged long-term interest rates of Greek debt are quantitatively related to the ratio of debt to GDP. The relationship shows that the market consistently expects default to occur if the Greek debt reaches twice the GDP. Our analysis does not preclude non-equilibrium increases in interest rates over shorter timeframes. We find evidence of such non-equilibrium fluctuations in a separate analysis. According to the equilibrium model, the date by which a half-default must occur is March 2013, almost one year after the actual debt write-down. Any acceleration of default by non-equilibrium fluctuations is significant for national and international interventions. The need for austerity or other measures and bailout costs would be reduced if market regulations were implemented to increase market stability to prevent the short term interest rate increases that make country borrowing more difficult. We similarly evaluate the timing of projected defaults without interventions for Portugal, Ireland, Spain and Italy to be March 2013, April 2014, May 2014, and July 2016, respectively. The markets consistently assign a country specific debt to GDP ratio at which default is expected. All defaults are mitigated by planned interventions.