How Sentiments Drive Economies and Crises?
Was the European debt crisis of 2011 avoidable?
Did you know that after the financial crash of 2007, the United States (U.S.) and the United Kingdom (U.K.) were in a worse economic state than the Eurozone? Yet, the sovereign debt crisis impacted the Eurozone much harder than the U.S. and the U.K.
A self-fulfilling prophecy can be defined as an instance or a situation in which preconceived notions or existing beliefs about the outcomes of certain events dictate people to act and behave in a manner that eventually makes these (less probable) outcomes more likely to manifest.
Merton (1948) has shown this phenomenon by including snippets from the era of the great depression. During this period, rumors of bank insolvency created a lot of uncertainty and chatter, leading people to make a bank-run resulting in an actual default, which otherwise could have been avoided.
Extensive research is being done on the role of self-fulfilling prophecies in social sciences, behavioral economics and other allied domains. In this article, I would like to talk about how human behavior and perceptions shaped one of the biggest global crises of the 21st century — The European debt crisis.
The European Debt Crisis of 2011
After the financial crash of 2007–08, governments were forced to bail out their banks to prevent a total collapse of their financial systems. This led to high debt to GDP ratios for economies like the U.S., U.K., and the Eurozone.
The debt to GDP ratios for the U.S increased faster than those of the U.K or the Eurozone. The main difference between these economies is that the U.S and the U.K are not a part of or do not form any monetary union.
Hence these independent economies can issue debt in their own currencies and thus, assure the bondholders that they would receive a payout at maturity.
In the case of the Eurozone (monetary union), member states have no control over the currency in which the debt is issued to the bondholders.
Hence these member states cannot always guarantee a payout at maturity to the bondholders. This phenomenon makes the Eurozone more sensitive to market fluctuations as compared to the independent nations.
Therefore, when member states of the Eurozone show a rise in their debt to GDP ratios, the bondholders and investors often fear an impending payout difficulty and a following recession.
This creates a sense of heightened uncertainty and bond owners rush to sell their bonds. This leads to decrease in the liquidity of the governments and an increase in interest rates and term spreads.
Thus, the newly created liquidity crisis cascades into a solvency crisis and finally into the most feared outcome — a recession. Here, we see the negative self-fulfilling prophecy at play. The fear of recession dictates humans to act in ways that increases the likelihood of a recession.
Human sentiments and negative self-fulfilling prophecies played a major role is shaping and deepening the sovereign debt crisis in Eurozone. The South-European nations, mainly Greece and Portugal are blamed for the crisis.
Grauwe and Ji (2012) show that the increase in interest rates and term spreads and the consequent degradation of bonds in the Eurozone was disjoint from the debt to GDP ratios and other fiscal parameters.
The debt ratios in Eurozone were not so high that they could justify such rapid degradation of bonds. This was the effect of the negative human sentiment and fear among the investors that motivated them to dump the bonds, raise interest rates and cause heightened uncertainty.
This in turn resulted in the crisis that the investors were fearing, thus reinforcing their original sentiments. Such negative sentiments and fears did not develop in the independent economies like the U.S and U.K despite the fact that their debt to GDP ratios and other fiscal parameters were in a worse shape than that of the Eurozone.
Thus, the U.S and the U.K were relatively shielded from the aftermath of the financial crisis of 2007 and the resulting European debt crisis. All of this, does raise an important question.
Was the European debt crisis avoidable?
To answer this question, we first need to understand a few things. Firstly, high debt to GDP ratios do not always signal towards a “doom and gloom” situation.
Countries like the U.S and Japan have been servicing high debts efficiently for years. This is clearly seen also from the fact that despite having high debt to GDP ratios during 2010–11, the U.S. did not experience a solvency crisis like the Eurozone did.
Secondly, human sentiments, perceptions and expectations play a major role in shaping global economies. If investors try to move away from their myopic visions and try to understand the dynamics of business cycles instead of reacting to every negative shock, liquidity crises can be avoided from turning into deep solvency crises.
Szokoloczy, the founder of Global Advisor, believed that the crisis of 2011 had eventually turned into a self-fulfilling prophecy. He points to the fact that media chatter about “doom and gloom” scares off businesses and investors.
This prompts them to put off any new investment and dump the so-called perceived risky bonds. Such actions, throw the economy into a spiral where term spreads skyrocket, bonds are degraded, governments are unable to roll-over and service debts efficiently and there is a general atmosphere of panic.
While we try to understand the impact of human sentiments on the crisis of 2011, it is also important to acknowledge that to ward off any deep recession or crisis, it is important to have proper fiscal and monetary policies in place along with the management of human perceptions and beliefs.
For instance, while Mario Draghi, the former president of ECB managed to put a stop on the downward spiral of the Euro and the Eurozone, his policies came into effect quite late.
An early intervention could have stopped the crisis from deepening further. However, better late than never, is what they say.
In hindsight, while it is difficult to say that the European debt crisis could have been avoided a 100%, it is safe to say that an inherent understanding of self-fulfilling prophecies, uncertainty management by media outlets and effective fiscal and monetary policies could have prevented the crisis from escalating further. The Eurozone would have bounced back much earlier than it did.
Is the Global recession of 2022 another example of an exacerbated crisis due to human sentiments? It remains to be seen.
