## 3.1 All Countries with Risk Premium Shocks had Unemployment Surges; and all Countries with Unemployment Surges had Risk Shocks ## Source details **Canonical URL:** [3.1 All Countries with Risk Premium Shocks had Unemployment Surges; and all Countries with Unemployment Surges had Risk Shocks](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019056.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2019/wpiea2019056.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2019/wpiea2019056.pdf.json) --- ### Key finding - There was no country with an unemployment surge that did not have a large risk premium shock; and there was no country with a large risk premium shock that did not have an unemployment surge. - Risk premium surges were associated with deep recessions and triggered labor shedding; in crisis countries employment declines were associated with sharp declines in wage shares, whereas in the euro area core wage shares increased. ### Evidence and mechanisms - Risk premia measured as the difference between local and German long-term interest rates. Years with high risk premia are identified when the difference is at least 400 basis points (threshold based on a CART decision tree analysis). - An “unemployment surge” is defined as an increase in unemployment of at least five percentage points (∆u_t > 0 for tin (t0,t1) for which u_t1 − u_t0 > 5). - Two reasons linking risk premia to unemployment surges: - Larger risk premium shocks are associated with larger declines in GDP. - Risk premium surges increase private sector financing costs, forcing firms to cut production and employment (akin to supply shocks), producing declines in wage shares and labor shedding. ### Illustrative comparisons and country outcomes - Baltic countries experienced risk premium shocks in 2008/09 and very sharp unemployment increases. - Euro area periphery saw a surge in risk premia in 2010 and beyond during the euro area sovereign debt crisis; core euro area countries managed to contain unemployment despite the common monetary policy. - Example contrast: Spain versus Finland — similar GDP declines but very different employment outcomes driven by risk premia: - Finland: export shock, but low risk premia → firms hoarded labor, decline in GDP offset by decline in labor productivity. - Spain: risk premium surge → labor shedding and increase in labor productivity exacerbated the GDP decline. ### Table 3.1 — Risk premium shocks and Unemployment Surges (selected entries) - Low risk premium peaks (Risk premium peaks at less than 350 basis points) - Germany: Risk premium peak 0.0 / Unemployment change 0.2 / GDP decline -5.6 - Denmark: Risk premium peak 0.4 / Unemployment change 3.8 / GDP decline -5.4 - Netherlands: Risk premium peak 0.5 / Unemployment change 3.7 / GDP decline -3.8 - Finland: Risk premium peak 0.5 / Unemployment change 3.0 / GDP decline -8.3 - Austria: Risk premium peak 0.9 / Unemployment change 1.9 / GDP decline -3.8 - Luxembourg: Risk premium peak 1.0 / Unemployment change 2.3 / GDP decline -5.6 - France: Risk premium peak 1.0 / Unemployment change 3.0 / GDP decline -2.9 - Belgium: Risk premium peak 1.6 / Unemployment change 1.5 / GDP decline -2.3 - Malta: Risk premium peak 2.6 / Unemployment change 0.9 / GDP decline -2.5 - Slovakia: Risk premium peak 3.1 / Unemployment change 4.9 / GDP decline -5.4 - High risk premium peaks (Risk premium peaks at more than 350 basis points) - Italy: Risk premium peak 4.0 / Unemployment change 6.6 / GDP decline -8.7 - Bulgaria: Risk premium peak 4.0 / Unemployment change 7.4 / GDP decline -3.6 - Slovenia: Risk premium peak 4.3 / Unemployment change 5.7 / GDP decline -9.6 - Spain: Risk premium peak 4.4 / Unemployment change 14.8 / GDP decline -8.9 - Estonia: Risk premium peak 4.6 / Unemployment change 12.1 / GDP decline -19.3 - Croatia: Risk premium peak 4.6 / Unemployment change 8.8 / GDP decline -11.6 - Cyprus: Risk premium peak 5.5 / Unemployment change 12.2 / GDP decline -10.2 - Ireland: Risk premium peak 7.0 / Unemployment change 10.5 / GDP decline -8.4 - Portugal: Risk premium peak 9.1 / Unemployment change 7.6 / GDP decline -7.9 - Latvia: Risk premium peak 9.1 / Unemployment change 13.4 / GDP decline -20.7 - Lithuania: Risk premium peak 10.8 / Unemployment change 12.0 / GDP decline -14.8 - Greece: Risk premium peak 21.0 / Unemployment change 19.1 / GDP decline -26.5 ### Risk premia, the Baltics, and the 2008/09 sudden stop - All measures of risk premia (the difference between long-term government bond yields and government bond yields in Germany, CDS spreads, etc.) increased in tandem. - The sudden stop in capital flows from Western European parent banks led to severe strain: capital flows from Western European parents into the region dropped sharply. - The result was not just a deep recession but also worries about the sustainability of the currency boards, which translated into high risk premia. - The corresponding figures for Estonia and Lithuania were 7.1 and 7.0 percent of GDP. - Adjustment in the Baltics was implemented upfront and was successful in compressing risk premia. ### The Euro Area Sovereign Debt Crisis (2010–2013): narrative and magnitudes - Before the global crisis, euro area periphery countries had large capital inflows, particularly from eurozone banks, contributing to high GDP growth, strong credit growth, rapid asset price increases, and high current account deficits. - After Lehman, banks reduced exposure to the private sector; capital flows dropped, credit booms ended, asset prices fell, and GDP declined. - Fiscal headline deficits projections: - Spring 2008 WEO: most 2009 headline deficits projected to be below 2 percent of GDP. - Spring 2010 WEO: 2009 headline deficits exceeded 10 percent of GDP in Greece, Ireland, and Spain. - Structural deficit revisions: - Pre-crisis structural balances revised down sharply; example: Ireland 2007 structural deficit estimate revised from 1/4 percent of potential GDP (Spring 2008 WEO) to 8 percent (Spring 2010 WEO). - Spain implemented 7 percent of GDP in stimulus measures during 2008-09. - Debt dynamics revisions: - Spring 2008 WEO projected most countries’ debt ratios to fall between 2007 and 2013. - Spring 2010 WEO showed many countries would see sharp increases. Example for Greece: - Spring 2008 WEO projected the debt ratio to decline by 20 percentage points between 2007 and 2013. - Spring 2010 WEO projected the debt ratio to increase by 50 percentage points—an increase in the projected debt change of 70 percentage points in two years. - Risk premia and yields peak (long-term government bond yields peaked at): - 36 percent in Greece (February 2012) - 16 percent in Portugal (February 2012) - 12 percent in Ireland (June 2011) - 7 1/2 percent in Italy (November 2011) - 6 1/2 percent in Spain (November 2011) - The rise in sovereign risk premia spilled over to the private sector, raising financing costs, forcing severe cost cutting by firms, reducing wage bills and wage shares, and sharply increasing unemployment. ### Fiscal sustainability, financing constraints, and macro feedbacks - When private sector output declined in 2009, public spending increased while tax revenues fell, opening a large gap between expenditure and revenue; fiscal stimulus aimed to restore private demand and tax revenues. - Financing availability constraint: - Large deficits could only continue as long as financing was available; with markets unwilling to finance large deficits, large scale consolidation became unavoidable. - In 2009, both Greece and Spain had a primary deficit of around 10 percent of GDP; a surge in risk premia following default could have increased primary deficits further via GDP decline and reduced revenue. - Fiscal consolidation effects: - Public expenditure in Greece was reduced by 25 percent. - Consolidation exacerbated the downturn and may have pushed up risk premia further, creating a vicious cycle: rising interest rates → falling GDP → lower tax revenues → further fiscal pressures. - Debt dynamics and growth interaction: - With a debt ratio of 100 percent of GDP and six percent nominal growth, a deficit of 6 percent of GDP stabilizes the debt ratio; with zero nominal growth, a balanced budget is required. - Forecasts of 2014 GDP declined in line with the rise in interest rates; causality may have gone both ways. - By Fall 2011, the projected 2014 debt ratio for Greece was higher than in Spring 2010 despite a sharp reduction in the structural deficit. - Central bank financing role: - The lack of a national central bank in euro area periphery countries meant no domestic central bank to step in and contain interest rates when capital fled; contrast with the United Kingdom and the United States where central banks purchased government bonds to bring down interest rates. - The euro area crisis ended only when ECB action (OMT announcement and Draghi’s “whatever it takes” statement) compressed risk premia and enabled recovery. ### Mechanisms, quantitative impacts, and country-level outcomes - Risk premium shocks reduced both demand and supply: firms cut output and employment; wage bills declined even faster than GDP. - Unemployment increases of 10–20 percentage points occurred in the Baltics and euro area periphery countries hit by large risk premium shocks. - The crisis in the euro area periphery was more protracted than in the Baltics; the GDP decline in Greece exceeded that in the Baltics. - Example of revision-driven crisis trigger: - Risk premia started to rise in fall 2010 after revelation that the Greek 2009 fiscal deficit would be 12 1/2 percent of GDP instead of 6 percent, worsening debt dynamics and prompting a vicious cycle of rising interest rates and falling GDP. ### Policy implications and recommendations - Prevention: - Avoid the build-up of macroeconomic vulnerabilities—large current account deficits or large fiscal deficits are especially dangerous for countries that do not have their own central banks. - Large pre-crisis imbalances correlate with the sharpest increases in risk premia when investor sentiment shifts. - Rapid response to risk shocks: - Bring down risk premia as quickly as possible because prolonged high risk premia prevent recovery by forcing firms to cut production and employment. - Adjustment needs to be upfront in some cases (as in the Baltics) but adjustment alone may not suffice. - Central bank intervention can be critical to compress risk premia quickly (as with ECB action ending the euro area crisis). - Recognize limits: - In an environment where financing is unavailable, less fiscal consolidation may not mitigate downturns and could lead to default and even higher risk premia. - Large fiscal multipliers in downturns make deficit reduction harder when financing dries up. ### Conclusion - Risk premium shocks can cause deep recessions and sharp unemployment increases in advanced countries, not only in emerging markets. - The global economic and financial crisis of 2008/09 and the euro area sovereign debt crisis in EU countries were significantly driven by large risk premium shocks in the Baltics (2008/09) and the euro area periphery (2010–13). - Policy priority: avoid macro vulnerabilities that make economies susceptible to risk premium shocks; when shocks occur, compress risk premia quickly through a combination of credible adjustment and, where available, central bank intervention. *Source: wpiea2019056 — Section 3.1* ### 3.1 All Countries with Risk Premium Shocks had Unemployment Surges; and all Coun- ### 3.1 All Countries with Risk Premium Shocks had Unemployment Surges; and all Countries with Unemployment Surges had Risk Shocks ### Key finding - There was no country with an unemployment surge that did not have a large risk premium shock; and there was no country with a large risk premium shock that did not have an unemployment surge. - Risk premium surges were associated with deep recessions and triggered labor shedding; in crisis countries employment declines were associated with sharp declines in wage shares, whereas in the euro area core wage shares increased. ### Evidence and mechanisms - Risk premia measured as the difference between local and German long-term interest rates. Years with high risk premia are identified when the difference is at least 400 basis points (threshold based on a CART decision tree analysis). - An “unemployment surge” is defined as an increase in unemployment of at least five percentage points (∆u_t > 0 for tin (t0,t1) for which u_t1 − u_t0 > 5). - Two reasons linking risk premia to unemployment surges: - Larger risk premium shocks are associated with larger declines in GDP. - Risk premium surges increase private sector financing costs, forcing firms to cut production and employment (akin to supply shocks), producing declines in wage shares and labor shedding. ### Illustrative comparisons - Baltic countries experienced risk premium shocks in 2008/09 and very sharp unemployment increases. - Euro area periphery saw a surge in risk premia in 2010 and beyond during the euro area sovereign debt crisis; core euro area countries managed to contain unemployment despite the common monetary policy. - Example contrast: Spain versus Finland — similar GDP declines but very different employment outcomes driven by risk premia: - Finland: export shock, but low risk premia → firms hoarded labor, decline in GDP offset by decline in labor productivity. - Spain: risk premium surge → labor shedding and increase in labor productivity exacerbated the GDP decline. ### Table 3.1 — Risk premium shocks and Unemployment Surges (selected entries) - Low risk premium peaks (Risk premium peaks at less than 350 basis points) - Germany: Risk premium peak 0.0 / Unemployment change 0.2 / GDP decline -5.6 - Denmark: Risk premium peak 0.4 / Unemployment change 3.8 / GDP decline -5.4 - Netherlands: Risk premium peak 0.5 / Unemployment change 3.7 / GDP decline -3.8 - Finland: Risk premium peak 0.5 / Unemployment change 3.0 / GDP decline -8.3 - Austria: Risk premium peak 0.9 / Unemployment change 1.9 / GDP decline -3.8 - Luxembourg: Risk premium peak 1.0 / Unemployment change 2.3 / GDP decline -5.6 - France: Risk premium peak 1.0 / Unemployment change 3.0 / GDP decline -2.9 - Belgium: Risk premium peak 1.6 / Unemployment change 1.5 / GDP decline -2.3 - Malta: Risk premium peak 2.6 / Unemployment change 0.9 / GDP decline -2.5 - Slovakia: Risk premium peak 3.1 / Unemployment change 4.9 / GDP decline -5.4 - High risk premium peaks (Risk premium peaks at more than 350 basis points) - Italy: Risk premium peak 4.0 / Unemployment change 6.6 / GDP decline -8.7 - Bulgaria: Risk premium peak 4.0 / Unemployment change 7.4 / GDP decline -3.6 - Slovenia: Risk premium peak 4.3 / Unemployment change 5.7 / GDP decline -9.6 - Spain: Risk premium peak 4.4 / Unemployment change 14.8 / GDP decline -8.9 - Estonia: Risk premium peak 4.6 / Unemployment change 12.1 / GDP decline -19.3 - Croatia: Risk premium peak 4.6 / Unemployment change 8.8 / GDP decline -11.6 - Cyprus: Risk premium peak 5.5 / Unemployment change 12.2 / GDP decline -10.2 - Ireland: Risk premium peak 7.0 / Unemployment change 10.5 / GDP decline -8.4 - Portugal: Risk premium peak 9.1 / Unemployment change 7.6 / GDP decline -7.9 - Latvia: Risk premium peak 9.1 / Unemployment change 13.4 / GDP decline -20.7 - Lithuania: Risk premium peak 10.8 / Unemployment change 12.0 / GDP decline -14.8 - Greece: Risk premium peak 21.0 / Unemployment change 19.1 / GDP decline -26.5 ### Implications - Country-specific private sector financing cost shocks can occur despite a common monetary policy; common monetary policy alone is not sufficient to prevent country-specific risk premium shocks. - Reductions in wage bills and wage shares in crisis countries were sharper than GDP declines, indicating strong labor shedding behavior when financing costs spike. - Restoring confidence and lowering risk premia (for example, large policy announcements that reduce perceived sovereign risk) can help lower financing costs, halt wage-bill declines, and support recovery. *Source: wpiea2019056 — Section 3.1* ### 1.1 billion USD in 2008Q3. ### wpiea2019056 - 1.1 billion USD in 2008Q3. ### Risk premia, the Baltics, and the 2008/09 sudden stop - All measures of risk premia (the difference between long-term government bond yields and government bond yields in Germany, CDS spreads, etc.) increased in tandem. - The sudden stop in capital flows from Western European parent banks led to severe strain: capital flows from Western European parents into the region dropped sharply. - The result was not just a deep recession but also worries about the sustainability of the currency boards, which translated into high risk premia. - The corresponding figures for Estonia and Lithuania were 7.1 and 7.0 percent of GDP. - Adjustment in the Baltics was implemented upfront and was successful in compressing risk premia. ### The Euro Area Sovereign Debt Crisis (2010–2013): narrative and magnitudes - Before the global crisis, euro area periphery countries had large capital inflows, particularly from eurozone banks, contributing to high GDP growth, strong credit growth, rapid asset price increases, and high current account deficits. - After Lehman, banks reduced exposure to the private sector; capital flows dropped, credit booms ended, asset prices fell, and GDP declined. - Fiscal headline deficits projections: - Spring 2008 WEO: most 2009 headline deficits projected to be below 2 percent of GDP. - Spring 2010 WEO: 2009 headline deficits exceeded 10 percent of GDP in Greece, Ireland, and Spain. - Structural deficit revisions: - Pre-crisis structural balances revised down sharply; example: Ireland 2007 structural deficit estimate revised from 1/4 percent of potential GDP (Spring 2008 WEO) to 8 percent (Spring 2010 WEO). - Spain implemented 7 percent of GDP in stimulus measures during 2008-09. - Debt dynamics revisions: - Spring 2008 WEO projected most countries’ debt ratios to fall between 2007 and 2013. - Spring 2010 WEO showed many countries would see sharp increases. Example for Greece: - Spring 2008 WEO projected the debt ratio to decline by 20 percentage points between 2007 and 2013. - Spring 2010 WEO projected the debt ratio to increase by 50 percentage points—an increase in the projected debt change of 70 percentage points in two years. - Risk premia and yields peak (long-term government bond yields peaked at): - 36 percent in Greece (February 2012) - 16 percent in Portugal (February 2012) - 12 percent in Ireland (June 2011) - 7 1/2 percent in Italy (November 2011) - 6 1/2 percent in Spain (November 2011) - The rise in sovereign risk premia spilled over to the private sector, raising financing costs, forcing severe cost cutting by firms, reducing wage bills and wage shares, and sharply increasing unemployment. ### Fiscal sustainability concerns, financing constraints, and macro feedbacks - When private sector output declined in 2009, public spending increased while tax revenues fell, opening a large gap between expenditure and revenue; fiscal stimulus aimed to restore private demand and tax revenues. - Financing availability constraint: - Large deficits could only continue as long as financing was available; with markets unwilling to finance large deficits, large scale consolidation became unavoidable. - In 2009, both Greece and Spain had a primary deficit of around 10 percent of GDP; a surge in risk premia following default could have increased primary deficits further via GDP decline and reduced revenue. - Fiscal consolidation effects: - Public expenditure in Greece was reduced by 25 percent. - Consolidation exacerbated the downturn and may have pushed up risk premia further, creating a vicious cycle: rising interest rates → falling GDP → lower tax revenues → further fiscal pressures. - Debt dynamics and growth interaction: - With a debt ratio of 100 percent of GDP and six percent nominal growth, a deficit of 6 percent of GDP stabilizes the debt ratio; with zero nominal growth, a balanced budget is required. - Forecasts of 2014 GDP declined in line with the rise in interest rates; causality may have gone both ways. - By Fall 2011, the projected 2014 debt ratio for Greece was higher than in Spring 2010 despite a sharp reduction in the structural deficit. - Central bank financing role: - The lack of a national central bank in euro area periphery countries meant no domestic central bank to step in and contain interest rates when capital fled; contrast with the United Kingdom and the United States where central banks purchased government bonds to bring down interest rates. - The euro area crisis ended only when ECB action (OMT announcement and Draghi’s “whatever it takes” statement) compressed risk premia and enabled recovery. ### Mechanisms, quantitative impacts, and country-level outcomes - Risk premium shocks reduced both demand and supply: firms cut output and employment; wage bills declined even faster than GDP. - Unemployment increases of 10–20 percentage points occurred in the Baltics and euro area periphery countries hit by large risk premium shocks. - The crisis in the euro area periphery was more protracted than in the Baltics; the GDP decline in Greece exceeded that in the Baltics. - Example of revision-driven crisis trigger: - Risk premia started to rise in fall 2010 after revelation that the Greek 2009 fiscal deficit would be 12 1/2 percent of GDP instead of 6 percent, worsening debt dynamics and prompting a vicious cycle of rising interest rates and falling GDP. ### Policy implications and recommendations - Prevention: - Avoid the build-up of macroeconomic vulnerabilities—large current account deficits or large fiscal deficits are especially dangerous for countries that do not have their own central banks. - Large pre-crisis imbalances correlate with the sharpest increases in risk premia when investor sentiment shifts. - Rapid response to risk shocks: - Bring down risk premia as quickly as possible because prolonged high risk premia prevent recovery by forcing firms to cut production and employment. - Adjustment needs to be upfront in some cases (as in the Baltics) but adjustment alone may not suffice. - Central bank intervention can be critical to compress risk premia quickly (as with ECB action ending the euro area crisis). - Recognize limits: - In an environment where financing is unavailable, less fiscal consolidation may not mitigate downturns and could lead to default and even higher risk premia. - Large fiscal multipliers in downturns make deficit reduction harder when financing dries up. ### Conclusion: role of risk premium shocks in advanced economies - Risk premium shocks can cause deep recessions and sharp unemployment increases in advanced countries, not only in emerging markets. - The global economic and financial crisis of 2008/09 and the euro area sovereign debt crisis in EU countries were significantly driven by large risk premium shocks in the Baltics (2008/09) and the euro area periphery (2010–13). - Policy priority: avoid macro vulnerabilities that make economies susceptible to risk premium shocks; when shocks occur, compress risk premia quickly through a combination of credible adjustment and, where available, central bank intervention. *Source: wpiea2019056 - 1.1 billion USD in 2008Q3.* --- _Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019056.pdf_