How did the subprime crisis in the US morph into a crisis of sovereign debt in the euro zone countries? From its introduction in 1999 to the start of the subprime crisis in mid-2007, spreads over German bunds or government bonds on euro zone countries were very modest and moved in a narrow zone. This paper tells the story of how and why this changed, bringing us to the present when speculation is rife whether the euro zone will survive.

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Earlier, Reinhart and Rogoff had pointed out in their comprehensive study of banking crises that banking crashes are usually followed by fiscal crises. They also said that sovereign debt ratios and the likelihood of sovereign defaults also rise after such crises. Mody and Sandri take the story forward, telling us that while a surge in private debt may be the immediate reason for a banking crisis, the fiscal and banking crises reinforce each other.

The authors say that the Bear Stearns rescue led to the presumption that banks would be rescued and therefore linked a euro zone member-country’s sovereign debt to the state of its banking system. Sovereign spreads increased in response to the perceived weakness of a country’s banks. After the nationalization of Anglo Irish Bank, this relationship was cemented. Countries whose initial debt-to-gross domestic product ratios were higher were affected the most. Also, the countries which were the least competitive were affected the most because the financial crisis led to a substantial pruning of growth prospects, particularly because the euro zone countries do not have the option of devaluing the currency. That in turn led to a belief that their public debt would prove to be unsustainable. The resulting higher spreads affected the banks holding the government’s bonds, which in turn raised fears of the government having to bail them out and all this resulted in an adverse feedback loop. Mody and Sandri conclude: “With the fiscal room for intervention much more limited, the eurozone economies have moved to a new, more stressed regime from which there is no quick return."

The authors believe that the priority must be to protect the banks, even if that entails higher fiscal costs. Once the banks are protected, growth too will revive. While that conclusion may be debatable, the paper presents the detailed story of how the euro zone got into its current mess.

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