Democratic Risk, the Great Recession, and the Euro Crisis

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1 Democratic Risk, the Great Recession, and the Euro Crisis Paper presented to the European Union Democracy Observatory EUDO Conference, European University Institute, Florence, November, Iain McMenamin, Michael Breen, and Juan Muñoz-Portillo Centre for International Studies, School of Law and Government, Dublin City University +353 (0) Acknowledgment: This work was done with the financial assistance of a Collaborative Research Project Grant from the Irish Research Council.

2 Introduction Democratic risk: the impact of elections on government bond interest rates Spillover: the impact of one country s election on another country s interest rate We investigate both the size and nature of spillovers. Different types of spillover have very different political implications. How distinctive is democratic risk in the euro crisis? Comparison with previous eras and a placebo group of non-european countries. How common are different types of spillovers? Within the eurozone, which countries produce the largest spilloversand the most asymmetric spillovers?

3 Event Study Methodology We compare the interest rate on ten-year government bonds after the event to a counterfactual. We regress a country s interest rate on the US ten-year bond for five of the six months before the election, excluding the last one. This enables us to predict the normal return. We compare this to the interest rate after the election to calculate the abnormal return. We cumulate the abnormal returns for five days after the event the cumulative abnormal return (CAR).

4 Samples (Future) eurozone: Austria, Belgium, Finland, France, Germany, Ireland, Italy Netherlands, Portugal, Spain (Quasi-)Placebo Group: Australia, Canada, Japan, New Zealand

5 Election Spillover Cumulative Abnormal Return (5 days) (Future) Eurozone (Quasi-)Placebo Group

6 Elections and Bond Market Spillover in the Euro Crisis Boxplot Spain Spain Portugal Portugal Ireland Portugal Ireland Spain Spain Italy France Germany Germany Germany Spain Ireland Portugal Portugal Spain 2008 Italy 2008 Austria 2008 Germany / Portugal 2009 Netherlands 2010 Belgium 2010 Ireland 2011 Finland 2011 Portugal 2011 Spain 2011 France 2012 Netherlands 2012 Benchmarked on US bond Cumulative Abnormal Return (5 days)

7 Geert Wilders of the Party of Freedom. His party more than doubled its seat numbers in the Dutch election of 2010 but lost half its vote share in the 2012 election.

8 Types of Spillover 1. Aligned: Event has similar impact in event country and spillovercountries. Other types of spillover are asymmetric. 2. Negative Skew: The event reduces the interest rate in the spillovercountries by substantially more than the event country. 3. Positive Skew: The event increases the interest rate in the spillovercountries by substantially more than the event country. 4. Redistribution: The impact on the spillovercountries varies, with some interest rates increasing, and some reducing, substantially more than the event country.

9 Election Spillover Types in the (future) Euro zone Pre onwards Prop. Elec. Spill. Prop. Elec. Spill. Prop. Elec. Spill. Redist Pos Neg Align Redistribution is the predominant type in the pre-euro era and alignment dominates in the early euro period. During the crisis, there bas been a mix of types. The contrast between the early-euro and euro crisis periods is stronger in the placebo group.

10 Vulnerability and Spillover in the Euro crisis Max. Interest Event-country Rate CAR Spillover Type Spillover Range France Redistributive Netherlands , Redistributive, 4.17, Negative Skew Finland Positive Skew Austria Redistributive 1.94 Belgium Redistributive 4.25 Spain , Aligned, 1.15, 7.57 Negative Skew 6.49 Italy Aligned 0.54 Ireland Redistributive 4.79 Portugal Negative Skew 3.71 The greatest event-country impacts are from elections in vulnerable countries. The greatest spillover range and the greatest proportion of redistributive types of spillover are in the strong countries.

11 Conclusions Prior to 2000 and since 2007 substantial democratic risk has been present in rich-world elections. The euro zone s specificity is that democratic risk cannot be managed domestically. Democratic risk tends to be asymmetric. The greatest spillovers were associated with the strongest eurozone members. Implications In good economic times, strong countries long-term interest in the economic health of their partners is consistent with their short-term interest in low yields on their own public debt. In bad economic times, strong countries long-term interest in the prosperity of their partners tends to diverge from their short-term interest in cheap borrowing.

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