Rules and risks in the euro area. Bruegel Working Paper 2011/10, 4 October 2011

Wolff, Guntram B. and Iara, Anna (2011) Rules and risks in the euro area. Bruegel Working Paper 2011/10, 4 October 2011. [Working Paper]

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Abstract

Anna Iara and Guntram Wolff develop a model of sovereign spreads that are determined by the probability of default in interaction with the level of risk aversion. Estimation of the model confirms the central predictions. The legal basis for the rules, and mechanisms for enforcing them, are the most important dimensions of rules based fiscal governance. Highlights: With a unique data set summarising the quality of rules-based fiscal governance in European Union member states, we show that stronger fiscal rules in euro-area members reduce sovereign risk premia, in particular in times of market stress. • To do so, we develop a model of sovereign spreads that are determined by the probability of default in interaction with the level of risk aversion. Estimation of the model confirms the central predictions. The legal basis for the rules, and mechanisms for enforcing them, are the most important dimensions of rules based fiscal governance.

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