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Are Markets Rational When It Comes to Economic Fundamentals?

We hear frequently that financial markets thrive on irrational fears. That they are wrong to be wary of unreformed economies and that central banks are right to quell high sovereign borrowing rates with newly printed money.

This is an especially popular line of argument regarding the Euro Crisis, as European political leaders, EU officials, and academics tout it regularly. Paul De Gauwe of the London School of Economics and Yuemei Ji of the University of Leuven authored one of the prominent studies supporting this claim. But their methodology suffers from oversimplistic metrics for how markets view economic health and security of investment—termed “fundamentals” in financial lingo.

De Grauwe and Ji test the “market irrationality” hypothesis in two ways. First, they posit that if bond spreads decrease in response to European Central Bank (ECB) President Mario Draghi’s June 2012 announcement to do “whatever it takes” to maintain the euro, then ECB money printing can manage the Euro Crisis, which is a product of irrationally fearful markets, according to the “conventional wisdom.” An OLS regression of 10-year government bond spread changes since Draghi’s announcement upon initial bond spreads finds that spreads have indeed decreased.

Second, De Grauwe and Ji assess how markets respond to economic fundamentals by regressing country debt/GDP ratios on bond spread change since Q2 2012. They hypothesize that a positive relationship (spreads decreasing as debt burdens increase) would support the argument that market fears over European turmoil are irrational.  This is indeed the relationship that they find. Thus, De Grauwe and Ji conclude that Euro Crisis market jitters are irrational.

The problem is that the debt/GDP ratio is not a comprehensive indicator for economic fundamentals. A better measure, which takes into account security of property rights to freedom from corruption to the weight of the regulatory burden, is the Heritage Index of Economic Freedom. Upon regressing each European country’s overall rating upon its monthly 10-year government bond yields since 2008, I found that each one point increase in economic freedom led to a 14 basis point decrease in bond yields.

Yld v Rtg Blog Graph

Further, pursuing deficit reduction—a step toward better economic fundamentals (though this largely depends on the content of the austerity program)—leads to lower bond yields.  In the 24 months following implementation of each European country’s individual austerity program (dates available here), countries experienced a 1.3 percent monthly decline in their bond yields in relation to the 24 preceding months. The decline in spreads vis-à-vis Germany was even greater, at 3.5 percent per month (this value was statistically significant at the 90 percent level instead of the 95 percent level, however).

Financial markets do care about economic fundamentals. It is natural for bond yields to decrease across-the-board when the ECB declares itself as the surefire backstop behind the euro’s integrity, but that does not mean that individual yields do not also reflect a market assessment of country risk. Despite what the anti-austerians purport, markets reward fiscal responsibility with lower borrowing costs. Governments ought to pursue that reward, with or without the help of the central bank.