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.