The European Sovereign Debt Crisis and the Safe Asset Mechanism: A Markov-Switching Approach to Analyzing Sovereign Spreads

Abstract

The recent history of macroeconomics has been characterized by a series of crises and anomalies. After several decades of a stable paradigm, a flurry of new research is being produced by macro- and financial economists in order to better understand the circumstances we find ourselves in. One strand of this recent literature, pioneered by Ricardo Caballero, focuses on the role that the supply of, and demand for, safe assets can play in driving macroeconomic outcomes. In this literature, model economies switch abruptly from a normal regime into a regime where the spread between the interest rates on risky and safe assets is high, and output is low. I attempt to take Caballero's theory to the data, by estimating a set of Markov-switching models on European sovereign bond spreads and output gaps. While I do find evidence of regime-switching behavior in the time series, specific evidence in favor of Caballero's theory is lacking.