As the European Central Bank prepares to dig deeper for the billions of Euros to bail out Spain and Italy if necessary, scientists at the New England Complex Systems Institute have asked whether the Eurozone’s debt crisis was actually the result of flawed fiscal policies or blind panic in the markets. Their answer is: yes, the debt crisis is real, but that market overreactions made it much worse by driving interest rates higher at a critical time, leading policy-makers to over-react. The repercussions include the halving of Greek debt a year earlier than necessary had the markets been in equilibrium.

For the first time, NECSI’s study quantitatively demonstrates how interest rates implicitly behave according to sovereign debt. The bond market effectively has a pre-set debt threshold it expects a given country to default at. For each country, this value is always present in interest rates, even when default is unlikely. As sovereign debt approaches the threshold, however, interest rates rise until mounting pressure triggers a default. This is the pressure which forced Greece, Ireland, and Portugal to accept bailouts and adopt austerity measures, and which is currently mounting on Italy and Spain.

This is the type of equilibrium behavior that is generally assumed to be a feature of financial markets. By quantifying this behavior, however, the study lays the groundwork for spotting when interest rates are knocked out of equilibrium by external actors.

The study tracked annual interest rate changes from 2001 to the present. Long term, the annually averaged interest rates followed the equilibrium curve closely. But in 2011 and 2012, daily market interest rates rose much more rapidly than the equilibrium model would predict. In a separate study, NECSI’s researchers confirmed that when markets departed from equilibrium, there was insufficient economic justification for the increases. In these cases, bond prices were driven by speculator-led bandwagon effects, and perhaps even outright market manipulation.

“The vulnerability of sovereign debt markets to bandwagon effects has led to painful austerity measures that may not have been necessary,” says Professor Yaneer Bar-Yam, a co-author of the study. “Policy-makers should have had more time to devise and test alternative strategies.”

This includes the ECB’s recent offer to purchase short-term bonds in the secondary market that the bank’s president Mario Draghi promised would address “distortions in financial markets.”

“Having a common European response to the debt crisis is a good idea,” said Bar-Yam, who in past research has pointed out the flaws in leaving countries to face speculator attacks alone. “As a united front they are less vulnerable to speculative bubbles or crashes.”

Still, he emphasizes the importance of allowing markets to stabilize themselves. “The lack of stability is triggering policy responses that swing wildly every time the market hiccups because of the risk of crashes. If the markets were to be stabilized by simple trading policies, this wouldn’t be necessary.”

According to the researchers, policy-makers could respond only when there are real problems, not the phantoms generated by market panic.

You can Download the Paper here:

The European debt crisis: Defaults and market equilibrium