Fiscal space and sovereign risk pricing in a currency union

We examine how membership in a currency union affects public debt sustainability and market assessments of default risk in eurozone countries. We argue that there exist offsetting effects: expectations of bailouts tend to make a given level of debt more sustainable, lowering bond yields and CDS rates, but constraints on the use of monetary policy would tend to have the opposite effect, pushing rates up especially as room for fiscal maneuver gets exhausted. We develop a formal concept of fiscal space (which takes account of the notion of fiscal fatigue under which there are limits to the government's ability to raise the primary surplus in response to higher debt), and apply it to the eurozone countries, investigating in particular how currency union membership affects CDS and bond rates during both quiet and turbulent times for a given amount of fiscal space. We find that in quiet times, CDS and bond rates for eurozone members were below what would be expected given their fiscal space (a bonus from currency union membership). But when the crisis erupted, CDS and bond yields rose more sharply for eurozone members than would be predicted based on their available fiscal space. Our interpretation is that sovereign bailouts did not occur with the hoped-for alacrity in euro-crisis countries, generating sharper penalties for sovereigns that belong to a currency union. ► We examine how currency union membership affects sovereign risk pricing for eurozone countries given their fiscal space. ► We argue that it has offsetting effects on debt sustainability (possibility of transfers but constrained monetary policy). ► To control for fiscal space, we use a forward looking concept that works better than traditional indicators. ► We find that pre- (post-) crisis CDS and bond rates were below (above) those implied by eurozone members' fiscal space. ► Thus, when sovereign bailouts did not occur with the hoped-for alacrity, eurozone members were sharply penalized.