Political Systems, Financial Markets and Public Debt:

effects of political variables on the interest rates of public bonds in

different institutional contexts of the European Union*

Antonio Focella

Universit Bocconi

This paper intends to study how the different interest rates required by financial
markets on national public debt bonds, with respect to the benchmark represented by
the German bund, can be influenced by changes in characteristics of the political
systems of European states. The purpose is to examine the effects of such variations
on the main economies of the eurozone and of the European Union in times of
instability in financial markets, accounting also for institutional differences, features
which proves crucial when considering the effectiveness of government action in
dealing with financial crisis.

*I would like to thank professor Guido Tabellini for his most helpful review of earlier
stages of this work and professor Carlo Favero for his useful comments
Introduction

The mutual relations of influence between institutions and economic development have
since long been indicated as a key factor in understanding differences in the level of
development of different countries. Authors such as Adam Smith and Weber already
underlined the importance of such bound, while more recently empirical researches
were carried out by authors such as Persson and Tabellini (2003), and more in general
in the perimeter of the neo-institutionalism theory.

In contrast, relationships between politics and economic development were not

investigated in depth in economics at first, although in recent decades steps further
have been made in this field1. This should be a most welcome advancement, since on
average in OECD countries public expenditures account for about half of the GDP2.
This data alone explains the relevance of such research branch and how pervasive the
action of governments can be in influencing markets.

A particular phenomenon, which gained attention in the academic environment in the

last decade of the 20th century, was the relationship between variations in politics and
public debt. This is a topical field nowadays, since prospects on the path of public debt
suggest that the track pursued by fiscal authorities in a number of industrial countries
might be unsustainable3. Still, theoretical models and empirical evidence regarding the
impact of changes in politics on public debt sustainability remain largely focused on
electoral cycles and partisan differences (Rogoff and Sibert 1988; Persson and
Svensson 1989; Rogoff 1990; Alesina and Tabellini 1990; Lockwood et. al 1994),
rather than on the composition and peculiar traits of the incumbent majority.

Purpose of this paper is to test how differences and variations in majorities of

institutionally different European countries affect the perception of financial markets on
the sustainability of public debt and, more in general, on the economic situation of the
country during periods of widespread financial instability.

1
Among the others: Alesina and Rodrik (1994), Knack and Keefer (1995), Barro (1999), Hall and Jones (1999),
Acemoglu (2005)
2
Source: General Government Spending, National accounts at a glance OECD 2015
3
On this topic, among the others: Cecchetti et al. The future of public debt: Prospects and implications, BIS
Working Paper 2010
The theory which we are going to test is the following:

A greater majority in the parliament allows to act effectively in times of crisis

compared to an unstable majority, since the former can convince markets of the
sustainability of public debt through fiscal policy and other channels such as
regulation or competition laws
A higher number of parties in coalition governments weakens the behavior of
the majority because of dealing costs between negotiators, harming policy
outcomes that should have reassured markets on the economic situation of the
country
The number of parties in parliament doesnt affect the conduct of the majority,
since more or less parties outside of the coalition majority shouldnt affect the
outcome of parliament votes and thus should have no effect on the interest rate
of public bonds

We argue that such correlations, although reasonable, are not straightforward. They
rather depend on elements such as the possible accountability of an international
organization for the countrys debt, the quality of institutions and of social capital, the
countrys dimension, and peculiar traits derived from different historical paths. Also,
the magnitude of such effects is not the same in all institutional contexts, differing
instead according to the nature of institutions.

Approach

The dependent variable used to verify effects of political variations is the spread
between the interest rate paid by the country on public debt bonds and the one paid
by the German Federal Republic, as reported by Eurostat4. This approach allows to
isolate the effect of premium at risk since the German Bund is considered a safe haven
asset which carries no possibility of default, however its interest rate still incorporates
all other components of nominal interest rates such as the reward for time and inflation
expectations. If markets perceive that the sustainability of the public finances of a
country has changed because of changes in the political equilibrium, then this should

4 Central government bond yields on the secondary market, gross of tax, 10 years' residual maturity
reflect on the interest paid by the government, and thus on the spread with the German
Bund (which instead carries approximately no risk premium).

The political variables studied to estimate variations in spreads are:

The vote percentage held by the government party in the main chamber of
representatives, as a proxy of its stability
The number of parties in the government, to account for wider coalitions
The number of parties in the main chamber

The dataset has been built on data provided by the ParlGov database (Dring and
Manow 2016) and the "World Bank Database of Political Institutions" (in its up-to-date
version), adapted and transformed to obtain the necessary variables used in
regressions.

Together with political variables, another variable is added in order to capture financial
markets volatility and thus recognize periods of financial instability. For this purpose, I
use two different measures5: the CISS index of systemic risk in financial markets built
by Holl, Kremer and Lo Duca (2012) and the most well-known VIX index derived by
the S&P 500 stock market index6. The main difference between the two is that the
CISS is conceptually founded on standard definitions of systemic risk. In fact, it
comprises the five arguably most important segments of an economys financial
system (bank and non-bank financial intermediaries, money markets, securities
markets and foreign exchange). On the other hand, the VIX measures the expectations
of volatility, since it is built on the current prices of options7. For this reason, when the
political variables are interacted with the CISS, the regression will consider mainly the
importance of politics in dealing with systemic threats. Instead, when they are
interacted with the VIX the regression will consider mainly the effects of politics in times

5
Another well-known uncertainty index, the Economic policy uncertainty index developed by Baker, Bloom
and Davis cant be used since it interferes with political transformation in examined countries
6
The coefficients when considering the CISS index will be greater than those obtained when using the VIX index
since CISS assumes values between 0 and 1, while the VIX assumes higher values
7
Since this index is generally considered the best gauge of fear in the market, it serves well for the end of
identifying times of instability (Bekaert and Hoerova 2014)
of high volatility. This instability rates are easily available since they are common
indicators in the main financial-economic databases.

Two control variables are considered, one for the economic side and another for the
political one. The first is the variation in unemployment rate provided by Eurostat (one
month delayed since markets can incorporate the information only after it is published)
to capture variations in the economic situation of different countries. The other control
is a caretaker variable (which indicates a caretaker cabinet with a limited legislative
mandate: non-partisan, provisional, technical or continuation cabinet) used to control
for periods in which standard political equilibria in the government are altered. This
variable is not interacted with the volatility index since only few observations are
available for the period. Thus, it will be considered only as a control variable rather
than a variable whose effect could be estimated.

Stable differences between countries are captured by the regression using fixed effect
for different countries, while common events affecting interests on public debt, as the
Outright Monetary Transactions enacted by the ECB since September 2012, are
captured using time fixed effects.

The research is focused on the interaction of the considered variables and the volatility
index in order to infer whether there are differences on the effects of the political
variables on spreads in periods of lower and higher financial fluctuations. Instead the
analysis of the effects of pure political variables is not the purpose of the paper.

The main instrument of the study is a panel data regression with time and country fixed
effects:

, = 1 , + 2 , + 3 , + + + ,

where Y stays for the value of spread, X represents the matrix of political variables, W
the control variables, Z is the variable which captures volatility (in each period included
in the time fixed effect), XZ the interaction of the variables, alpha is the country fixed
effect and gamma the time fixed effect.

In the regression, I consider the square root of the value both for the share of seats
and the interaction between share of seats and volatility index instead, of using a linear
relation. This decision derives from the idea that an increase in the share of seats is
more important if the government is supported by a small share of congressmen i.e.
if the majority increases its percentage of members of parliament from 52% to 55% the
effect on stability is very sensible, while the same increase from 72% to 75% would be
less meaningful since the majority was already stable from the beginning.

Framework

Gathered data go from August 2001 to November 2016. The choice of starting to
consider observations from this moment derives from the purpose of including in the
sample a period of turbulence before the one generated by the 2008 crisis, as the one
which followed the terrorist attack of 9/11/2001. A third notable moment of uncertainty
considered in the sample is given by the occurrence of Brexit during summer 2016.
Furthermore, as it can easily be imagined, during the European debt crisis there have
been long periods of instability, thus the indexes provide enough volatility to be
analyzed in the regression.

A limit of the approach is that it is hard to find a wide and organic sample of countries,
thus the analysis will be limited to a restricted set of states. This is a significant, yet
necessary, drawback in order to obtain coherent results8. Tested countries are the
eight major economies (by GDP) of the eurozone and two of the major economies of
the European Union: France, Italy, Spain, Poland, the Netherlands, Belgium, Austria,
the Czech Republic, Greece and Portugal. The choice of the sample is guided by the
idea that international investors would rather be informed of the political situation of
more relevant countries than of, for example, Estonia or Malta. The choice of including
the two biggest economies of eastern Europe is motivated by the purpose of acquiring
a general view of the phenomenon at a continental level. Poland and the Czech
Republic often kept their exchange rate at a fixed parity with the euro or around a
certain stable value set by their central banks9. Anyway, in order to avoid omitted
variable bias, crucial regressions are repeated considering only eurozone countries.

8
This also causes the R2 within to be particularly high in some regression because time fixed effects capture a
greater share of volatility when few countries are considered
9
The exchange rate in the considered period has been much more stable than, for example, the one between
the euro and the US dollar or the euro and the Japanese yen see Appendix
The general overview

To obtain a general view of the effects of political variables on the perceived risk of
public finances we run the regression on the complete panel and for the entire period.
This means that the regression will consider different institutional contexts and different
periods during which financial markets believes might have changed.

The first analysis, for a total of 1840 observations, gives the following results10:

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) -61.3 -104.2 658.4 600.7
(137.7) (144.4) (276.4)** (273)**
Parties in Parliament 2.2 5.4 1.7 6.0
(3.7) (3.7) (5.1) (5.0)
Parties in Government 30.7 -23.0 10.3 -3.2
(7.9)*** (8.2)*** (10.6) (10.4)
Sqrt(Share_Seats*volatility) -146.0 -29.63 -140 -103.9
(374.0) (366.5) (62.2)** (60.6)*
Parties_Parliament*volatility -7.6 -24.5 0.1 0.0
(13.6) (13.4)* (0.2) (0.2)
Parties_Government*volatility 38.0 75.0 1.2 1.7
(29.9) (29.5)** (0.5)** (0.5)***
Caretaker -4.8 82.3
(28.5) (33.4)**
Unemployment Change 252.7 249.1
(26.8)*** (26.6)***
Number of observations 1840 1840 1840 1840
R (within)
2
0.35 0.39 0.36 0.39
Table 1: European Union Countries, 2001-2016

At a first glance, political variables do not seem to be extremely important for financial
markets, the only variable which has a clear effect is the number of parties which form
the government. Once control variables are introduced, more parties having to bargain
before enacting policies are correlated to higher spread. Also, the share of seats has
an effect on risk premium when using the VIX indicator, however that is not the case
considering the CISS indicator, where the coefficient is still negative but not statistically
significant. This supports the position that political variables did matter but that, overall,
they were not a main determinant of interest rates on public bonds.

10
* = significance level at 90%; ** = significance level at 95%; *** = significance level at 99%
Two different paradigms

Yet, the first regression might not give realistic weight to political variables. An analysis
indistinctly considering the 2001-2016 period is probably flawed, as the relatively low
R2 suggests. Looking at the behavior of national spreads during this period, the
following graph suggests that there is an evident difference in the perceived country-
risks in the EU between the period since the birth of the euro to September 2008 and
the one after Lehman Brothers bankrupt. This difference is given by the different
awareness in stock markets of a possible disintegration of the monetary union and the
subsequent change in sustainability of national public debts. Before the crisis there
was a widespread belief that the members of the European Union would not have let
one of them default11. Yet, as the European debt crisis worsened, it became clear that
EU countries were not willing to just step in and bear the burden of foreign debt: the
situation started to be perceived more like an every man for himself.

Figure 1: European National Interests on Long Term Public Bonds

11
When the Greek crisis erupted all Europeans were emphatic that there was no need of external help and
that they could have managed the situation. They thought that calling in the IMF would be interpreted as a sign
of weakness on the part of Europe. In December 2009, the French president Mr. Sarkozy still said: I will never
allow the IMF in Europe
In fact, if we split the analysis into two different samples, one including observations
until the start of the great recession and the other including observations following
September 2008, we obtain an interesting comparison which offers more striking
results:

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) 63.0 -3.2 961.6 813.2
(77.1) (77.0) (189.5)*** (190)***
Parties in Parliament 3.0 3.3 5.6 5.5
(1.4)** (1.4)** (2.0)*** (2.0)***
Parties in Government -6.9 -7.8 -8.4 -7.7
(2.9)** (2.9)*** (4.3)* (4.3)*
Sqrt(Share_Seats*volatility) -65.8 46.8 -213.2 -182.1
(181.4) (180.0) (42.7)*** (42.8)***
Parties_Parliament*volatility -0.16 -3.1 0.0 0.0
(3.3) (3.3) (0.1) (0.1)
Parties_Government*volatility 4.2 7.8 0.0 0.0
(7.1) (7.0) (0.2) (0.2)
Caretaker 8.9 9.7
(10.0) (9.8)
Unemployment Change 42.1 35.7
(8.3)*** (8.1)***
Number of observations 840 840 840 840
R (within)
2
0.24 0.27 0.27 0.29
Table 2: European Countries, 2001-2008

Before the crisis political variables are not very useful to understand financial markets
behavior: none of the variables has a statistically significant effect in all controlled
regressions and the R2 is particularly low. Even when instability increased, the idea
that countries were bound together prevailed over single responsibility, and no higher
interest rate was asked by markets in order to finance public debt. Another possible
interpretation is that, even if financial markets considered risk premium and thus
economic differences mattered (although not much, comparing the impact of
Unemployment change to the one in the previous regression, which had a coefficient
over five times higher12), politicians in charge did not see any danger in the

12
About the perception of economic indicators by markets before the crisis see Beirne, Fratzscher The pricing
of sovereign risk and contagion during the European sovereign debt crisis ECB working paper series
sustainability of public debt. Thus, prior to 2008 politicians did not act to improve their
national economies because of pressure on interest rates, even if they had a solid
majority in parliament or if they werent constrained by wider coalitions. The belief that
a possible crisis would be dealt with at a continental level and that other countries
would step in to help a government which might risk default, although might have
avoided liquidity crisis, seems to have weakened the incentives on responsible
management of public finances.

Looking at the great recession, instead, political variables prove to be a more useful
instrument to understand the behavior of public debt creditors in relation to believes on
the sustainability of debt.

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) 126.9 76.5 732.5 697.3
(154.9) (177.9) (364.2) (367)*
Parties in Parliament 9.1 13.2 3.9 10.3
(5.4)* (5.3)** (7.0) (6.8)
Parties in Government 3.8 -3.0 -31.5 -49.2
(10.5) (12.5) (14.4)** (15.9)***
Sqrt(Share_Seats*volatility) -1076.7 -1121.8 -212.2 -215.0
(428.2)** (415.9)*** (77.0)*** (74.3)***
Parties_Parliament*volatility -7.9 -25.9 0.3 0.1
(23.0) (22.3) (0.3) (0.2)
Parties_Government*volatility 229.4 318.0 3.2 4.3
(54.3)*** (53.3)*** (0.6)*** (0.6)***
Caretaker -42.4 -29.4
(41.4) (40.5)
Unemployment Change 290.3 298.6
(34.8)*** (34.4)***
Number of observations 1000 1000 1000 1000
R (within)
2
0.34 0.39 0.35 0.41
Table 3: European Countries, 2008-2016

Share of seats and number of parties in government now clearly matter in all
regressions. Also, the R2 improved not only with respect to the 2001-2008 sample but,
once control variables are used, also with respect to the regression considering all
observations. When investors understood that the European Union was not as solid as
it seemed, and that each country would have been accountable for its own debt, the
internal situation of member countries began being watched closely (Schuknecht, von
Hagen and Wolswijk 2010). At the same time, governments which were solid enough,
and not weakened by internal bargaining, started enacting to contrast the recession,
while those which lacked such features saw their spreads rise.

A first insight from the empirical evidence is that the internal political situation matters
only if a country is considered the main accountable subject for its debt. If, instead, an
international or supranational organization is believed to step in, should financial
difficulties arise, investors will not consider political variables as much.

Although purely political variables are not the object of this research, an element worth
noticing, which has already emerged and that will occur again, is that spread shows a
tendency to grow as the share of seats (not interacted with a volatility index) grows.
This evidence suggests that in standard times stable governments usually do not act
to stabilize debt. They rather seek citizens approval with expansionary measures as,
for example, Italian prime minister Mr. Renzi did on May 2014 with the 80 bonus
during a period of low spread. Only when financial instability grows, share of seats
matters to regain markets trust, as the variable Sqrt(Share_Seats*volatility) shows.

Results change excluding Poland and the Czech Republic, focusing on the eurozone:

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) -191.5 -293.3 -2594.4 -2486.1
(575.3) (600) (1073.6)** (1054.5)**
Parties in Parliament 7.3 12.5 -12.4 -2.4
(6.8) (6.6)* (9.1) (8.9)
Parties in Government -3.9 -4.4 3.2 -13.1
(14.4) (17.2) (20.1) (22.3)
Sqrt(Share_Seats*volatility) 1592.1 1224.4 648.9 578.2
(1509.2) (1506.8) (231.8)*** (225.1)**
Parties_Parliament*volatility 44.5 12.2 1.2 0.8
(30.9) (30.2) (0.3)*** (0.3)**
Parties_Government*volatility 85.2 201.9 0.5 2.0
(79.8) (79.5)** (0.9) (0.9)**
Caretaker -68.8 -59.0
(48.2) (45.6)
Unemployment Change 280.6 289.9
(40.9)*** (40.2)***
Number of observations 800 800 800 800
R (within)
2
0.38 0.43 0.41 0.45
Table 4: Eurozone Countries, 2008-2016
Now the number of parties in the government is the only statistically significant
interacted political variable, while the share of seats, although non-significant when
using the CISS indicator, if so ever might indicate a tendency opposite to the more
reasonable one of parliamentary majorities which commit to reassure the markets
about their financial solidity13.

Is it possible that political elites of eastern Europe proved better than western ones in
dealing with financial instability? Actually, it should be considered that this panel
includes heterogeneous countries which faced the crisis in different ways and starting
from different fundamentals. Some of these countries, as Greece and Portugal, were
experiencing severe recessions, having to deal with a particularly high pressure in
consideration of the dimensions of their economies. In such situations politics could do
little, being so strongly overwhelmed by economic circumstances. On the other side,
northern countries were in much better shape, from an economic point of view (or at
least they were perceived to be so).

Virtuous countries and PIGS

Countries have been divided into different categories during the crisis. The most well-
known partition is certainly the one between PIGS (Portugal, Italy, Greece and Spain)
and northern countries. This partition was based on a narrative which stated that
Mediterranean countries had weaker economic fundamentals and had not invested in
productive economic sectors during favorable years, while northern countries had
virtuously kept their balances in order. It is not the purpose of this paper to ensure
whether this position was based on evidence or not, still we borrow this view and adapt
it at a political system level.

To begin with, we split the complete sample, including non-euro countries, in order to
obtain a first very approximate view at a continental level. A regression run on France,
the Netherlands, Austria and the Czech Republic confirms that these countries,
considered the responsible side of the European Union, show a political class capable
of positively acting in times of crisis: political stability grants an effective action in

13
This tendency might be a result of including observations from the year 2008 and the beginning of 2009,
when the European crisis hadnt begun yet and there was still little pressure on European countries. This thesis
is backed by the results of a regression considering only observation in the period 2010-2016, where the
coefficient Sqrt(Share_Seats*volatility) is negative and significant see Appendix
reassuring markets and assures saving on interests on public debt. On the other hand,
wider coalitions remain a problem because of coordination costs. Interestingly, a higher
number of parties in parliament in times of crisis seems to have a positive effect on a
countrys spread.

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) 150.3 115.5 375.5 336.3
(23.9)*** (27.7)*** (46.1)*** (48.3)***
Parties in Parliament 1.5 1.2 4.0 3.7
(0.8)* (0.8) (1.0)*** (1.0)***
Parties in Government -22.3 -20.1 -21.7 -20.3
(4.1)*** (4.1)*** (5.6)*** (5.6)***
Sqrt(Share_Seats*volatility) -471.3 -437.0 -80.4 -76.6
(58.9)*** (60.1)*** (9.3)*** (9.4)***
Parties_Parliament*volatility -25.0 -25.1 -0.3 -0.3
(3.1)*** (3.1)*** (0.0)*** (0.0)***
Parties_Government*volatility 68.1 56.4 0.3 0.3
(20.0)*** (20.5)*** (0.2)* (0.2)
Caretaker -18.2 -17.2
(7.6)** (7.4)**
Unemployment Change 6.8 8.3
(9.1) (9.0)
Number of observations 400 400 400 400
R (within)
2
0.80 0.80 0.80 0.80
Table 5: European Virtuous Countries, 2008-2016

Instead, if we look at countries with a reputation of being less virtuous, such as Italy,
Spain, Greece, Portugal and Poland, the political class does not perform as well:
although coefficients for the share of seats covaried for volatility are higher than in
northern Europe, the variable is not always statistically significant. This means that,
even if these countries had to approve more pervasive maneuvers, with respect to
those enacted by northern countries, in order to regain markets trust (a strong majority
seems to have a sensible effect on spread, i.e. the coefficient for
Sqrt(Share_Seats*volatility) is particularly high), such maneuvers werent always
successful, as the low significance shows. Also, a more fragmented government
increases risk premium required by markets, while the effects of a more fragmented
parliament are not statistically significant.
 Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX
No controls With controls No controls With controls
Sqrt(Share of Seats) 1849.4 1853.0 1363.7 2054.9
(980.9) (982.8) (2476.9) (2411.8)
Parties in Parliament 42.9 50.4 13.5 28.8
(12.9)*** (12.5)*** (14.7) (14.4)**
Parties in Government -54.3 -61.4 -84.2 -121.2
(23.9)** (28.5)** (46.5)* (48.2)**
Sqrt(Share_Seats*volatility) -5463.2 -6209.2 -320.9 -531.3
(2710.4)** (2618.1)** (555.9) (536.8)
Parties_Parliament*volatility 91.5 25.9 2.1 1.2
(51.3)* (50.9) (0.6)*** (0.6)**
Parties_Government*volatility 327.2 547.6 4.0 6.9
(172.7)* (169.0)*** (2.5) (2.4)***
Caretaker -94.0 -85.1
(82.4) (79.1)
Unemployment Change 349.1 335.3
(58.7)*** (58.0)***
Number of observations 500 500 500 500
R (within)
2
0.56 0.60 0.57 0.61
Table 6: European non-Virtuous Countries, 2008-2016

To interpret the North-South dichotomy at best, we now compare a subgroup made

out of Austria and the Netherlands with PIGS countries. By doing this, we get a
comparison which focuses only on euro currency countries and we eliminate the
distortion represented by France - a country which has been accused of being closer
to Mediterranean countries rather than to northern ones14. Thus, the comparison is
between the countries closest to the German situation15, known for having supported
austerity and for having maintained fiscal balances, and the countries identified as the
economic problem of the eurozone.

The two countries considered flagships of austerity show a more effective action of
government majorities even compared with the group of European virtuous countries
as a whole, as Sqrt(Share_Seats*volatility) value shows.

14
Patrick Allen, "Should France be added to the 'PIIGS'?" CNBC
15
Julian Rappold, Are austerity measures leading to a North-South divide? Heinrich-Bll-Stiftung European
Union
 Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX
No controls With controls No controls With controls
Sqrt(Share of Seats) 244.7 336.4 535.6 582.5
(86.1)*** (96.8)*** (152.7)*** (150.5)***
Parties in Parliament 4.1 2.4 8.8 6.1
(4.0) (4.1) (4.3)** (4.4)
Parties in Government -17.0 -17.3 -24.5 -26.2
(8.2)** (8.4)** (11.9)** (11.9)**
Sqrt(Share_Seats*volatility) -573.0 -735.2 -97.6 -100.2
(281.9)** (290.5)** (35.3)*** (34.5)***
Parties_Parliament*volatility -44.3 -46.1 -0.4 -0.4
(12.1)*** (12.0)*** (0.1)*** (0.1)***
Parties_Government*volatility 165.4 168.5 1.3 1.4
(47.8)*** (48.2)*** (0.5)** (0.5)***
Caretaker 12.6 14.4
(6.2)** (5.8)**
Unemployment Change 2.8 2.0
(8.9) (8.7)
Number of observations 200 200 200 200
R (within)
2
0.90 0.90 0.89 0.90
Table 7: Netherlands & Austria, 2008-2016

PIGS countries, on the other hand, do not show a similar clear correlation between
political variables in times of crisis and spread. The hypothesis of more incisive
policies, although not always effective, seems confirmed, since the coefficients of
Sqrt(Share_Seats*volatility) are higher than those in virtuous countries, but not
always significant. The evidence seems also to confirm that in such countries the loss
of stability (as an example because a government loses his parliamentary majority)
has a much greater effect than in other European countries: a political crisis is much
costlier in southern Europe. At the same time, markets should not only worry about
such countries finding a parliamentary majority, but also about the characteristics of
the government: low significance implicates that not all stable majorities prove
effective. As an example, looking at the number of parties in the government, such
variable results significant (and more penalizing than in Austria or the Netherlands),
since it represents the problem faced by the governments of these countries when
needing wide approval to pass important reforms while dialoguing with many
interlocutors.
 Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX
No controls With controls No controls With controls
Sqrt(Share of Seats) 1846.1 1571.7 347.8 870.6
(1218.1) (1241.3) (3089.5) (3060.5)
Parties in Parliament 36.8 40.4 13.7 26.2
(21.9)* (21.3)* (22.4) (22.0)
Parties in Government -57.5 -49.7 -49.4 -71.8
(28.5)** (34.2) (58.5) (61.0)
Sqrt(Share_Seats*volatility) -5923.4 -6013.1 -132.9 -319.8
(3290.4)* (3231.5)* (688.7) (676.7)
Parties_Parliament*volatility 48.7 -8.3 2.1 1.3
(5.0) (55.0) (0.6)*** (0.6)**
Parties_Government*volatility 241.6 421.9 1.5 4.3
(205.1) (202.5)** (3.1) (3.1)
Caretaker -136.9 -136.9
(89.0) (85.4)
Unemployment Change 271.7 249.1
(66.7)*** (66.4)***
Number of observations 400 400 400 400
R (within)
2
0.64 0.67 0.66 0.68
Table 8: PIGS Countries, 2008-2016

The data seem to support the mainstream view of a European continent split along a
latitudinal axis also regarding political systems. The political classes of northern
countries proved more effective in contrasting the challenges of economic crisis and,
in general, in facing situations of instability. In southern countries, instead, politics
seemed less effective in reducing required premium at risk and in dealing with public
debt problems, performing particularly poorly when it comes to coordinate different
parties forming the majority.

Quality of institutions and social capital

A possible explanation for this discrepancy might come from differences in the quality
of institutions and in social capital.

Policies are less effective if institutions are weak (Helmke and Levitsky 2003). Though
large part of Europe ranks among the worlds most-developed regions in terms of
institutional quality, the level varies considerably across the continent. An elaboration
based on data from the World Bank and from the World Economic Forum on
institutional strength, legal protection and absence of corruption shows the distance
between our two subsets16:

Northern Countries

Country Institutional Strength Legal Protection Absence of

Corruption
Netherlands 1.62 1.61 1.96
Austria 1.51 1.74 1.21
Mean 1.57 1.68 1.58

Mediterranean Countries

Country Institutional Strength Legal Protection Absence of

Corruption
Italy 0.49 -0.19 -0.38
Spain 0.83 0.48 0.21
Greece 0.28 -0.22 -0.29
Portugal 0.99 0.88 0.68
Mean 0.65 0.24 0.06

Policies are also less effective if social capital is missing: as Nannicini et al. (2010)
state, in national contexts characterized by low civism and trust, political misbehaviors
are more frequent compared with those where civic attitudes are widespread. Applying
this intuition on the management of public debt offers a reasonable explanation of the
current discrepancy in the effects of European politics.

16
Soure: Briegel and Bruinshoofd (2015). Data refer to 2013. IS is based on the unweighted average of the six
sub-indicators of the World Banks World Governance Indicators and the Ease of Doing Business Index. LP is
constructed as the unweighted average of the Enforcing Contracts sub-indicator of the World Banks Ease of
Doing Business Index, the Rule of Law sub-indicator of the World Bank Governance Indicators, and the Property
Rights indicator of the World Economic Forums annual Global Competitiveness Index. The AC is based on an
unweighted average of the Control of Corruption sub-indicator of the World Governance Indicators and the
Ethics & Corruption sub-indicator of the Global Competitiveness Index
Reporting estimates on social capital taken from van Oorschot, Arts and Gelissen
(2006) shows how countries in which political class proved less efficient in dealing with
crisis are those characterized by a lower value on social capital indicators17:

Northern Countries

Country Trustworthiness Political Trust in Generalized

Engagement Institutions Trust
Netherlands 35.1 6.0 15.6 1.6
Austria 34.9 6.1 16.5 1.3
Mean 35.0 6.05 16.05 1.45

Mediterranean Countries

Country Trustworthiness Political Trust in Generalized

Engagement Institutions Trust
Italy 35.9 5.6 13.9 1.3
Spain 34.5 5.1 15.1 1.4
Greece 29.7 6.1 12.1 1.2
Portugal 35.3 5.2 14.5 1.1
Mean 33.85 5.2 13.9 1.25

An example of how these characteristics can affect the performance of a government

is in a country with low social capital which must enact pervasive reforms to get out of
an economic crisis. In this context lobbies are more likely to extort a preferential
treatment from the government at the expense of collective welfare (this is exactly what
happened in Italy when Prime Minister Mr. Monti tried to reform the taxi-drivers sector
to increase competition during a period of speculation on Italian public debt18).

17
Source: van Oorschot, Arts and Gelissen Social Capital in Europe: Measurement and Social and Regional
Distribution of a Multifaceted Phenomenon, Acta sociologica (2006) own elaboration
18
Steve Scherer Italy taxi drivers to strike against Monti reform Reuters, Jan 11, 2012
Country dimension
Looking then at the effects of variables after dividing Mediterranean countries into a
group which includes the bigger economies (Italy and Spain) and another including the
smaller ones (Greece and Portugal) provides interesting insights:

Variable name Italy & Spain Italy & Spain Greece & Portugal Greece & Portugal
Vol_index:CISS Vol_index:VIX Vol_index:CISS Vol_index:VIX
Sqrt(Share of Seats) 1297.1 332.0 -1152.8 -725.4
(588.8)** (1012.0) (2064.3) (5954.5)
Parties in Parliament 54.4 49.3 -163.9 -131.2
(16.4)*** (19.9)** (45.4)*** (94.2)
Parties in Government -10.9 -11.4 322.9 135.5
(7.7) (16.8) (129.4)** (278.7)
Sqrt(Share_Seats*volatility) -5702.9 -96.2 -4366.7 -27.4
(2328.3)** (250.4) (6521.2) (1352.3)
Parties_Parliament*volatility -86.2 -0.9 2372.7 11.6
(59.1) (0.7) (348.4)*** (4.4)**
Parties_Government*volatility 289.5 1.1 -456.9 -1.2
(101.6)*** (1.0) (736.8) (12.1)
Caretaker -26.1 -26.9 -1155.5 498.5
(14.1)* (13.2)** (824.1) (750.1)
Unemployment Change 15.1 15.7 66.5 217.6
(15.5) (15.9) (105.8) (122.3)*
Number of observations 200 200 200 200
R (within)
2
0.98 0.98 0.94 0.91
Table 9: Mediterranean Countries Comparison, 2008-2016

In this case, we cannot distinguish subsets on the basis of the quality of institutions
and of social capital, since the four countries score approximately alike in all indicators.

Looking at empirical evidence, smaller economies show a worse performance: the

interacted share of seats variable has a lower impact and is much less significant
compared with the Italian and Spanish sample, while the number of parties in
parliament proves particularly problematic, a phenomenon we had not observed in
previous regressions19.

19
Such evidences are confirmed by regressions run on single Mediterranean countries. Since time fixed effects
could not be used I added the volatility index as a pure variable to distinguish periods of generalized higher
markets instability
Why should Greece and Portugal be in a more difficult position to answer the challenge
of an economic crisis with respect to other bigger countries in a similar position, as
might be Italy or Spain? A first element which
should be considered is that Greece and
Portugal are more open to trade than their
Mediterranean colleagues. When a country
with a very open economy is hit by an external
shock, politics has narrower room of
maneuver, since its influence on foreign actors
is much weaker than on national ones. On this
topic, Streeten (1993) and Easterly and Kraay
(2000) state that small economies (as Greece
and Portugal) tend by their very nature to have
high foreign trade risk.

A second element to be considered, as Kdr (1981) states, is that smaller countries

seem to suffer more during global fluctuations because of their weaker background
and diversification, a thesis backed by a more recent paper by the IMF (2013). Kdr
(1973) also stresses the difficulties faced by small economies in an over-national
union, as is the case for Greece and Portugal in the EU.

Overall is reasonable to affirm that political effort, in a period of widespread financial

instability, is weakened in countries characterized by smaller economies.

From this theoretical and empirical standing point, it should be expected that other
small and extensively open to trade European countries, as Austria, Belgium or the
Czech Republic, would incur in hard times, should for some reasons financial markets
start to doubt about the sustainability of their public debts. In such a situation
government action might prove constrained - and thus less effective - than in bigger
countries.
Eastern Democracies

We can then use again data on Poland and the Czech Republic to compare the
situation in the two young democracies of eastern Europe with the different categories
inside the eurozone.

Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX

No controls With controls No controls With controls
Sqrt(Share of Seats) 273.2 -136.3 571.0 -442.6
(44.6)*** (286.7) (118.3)*** (273.3)
Parties in Parliament 6.5 4.8 4.7 -0.8
(2.1)*** (2.5)* (4.1) (4.1)
Parties in Government -41.2 -37.8 -55.1 -42.0
(7.4)*** (7.8)*** (13.7)*** (13.1)***
Sqrt(Share_Seats*volatility) -898.1 -730.0 -127.5 -81.9
(112.0)*** (165.0)*** (24.3)*** (25.3)***
Parties_Parliament*volatility -13.6 -13.3 -0.1 0.1
(12.6) (12.9) (0.2) (0.2)
Parties_Government*volatility 218.6 155.9 2.0 1.0
(36.7)*** (56.9)*** (0.5)*** (0.6)*
Caretaker -278.7 -627.3
(192.0) (157.8)***
Unemployment Change 6.6 36.7
(19.5) (20.0)*
Number of observations 200 200 200 200
R (within)
2
0.95 0.95 0.94 0.95
Table 10: Eastern European Countries, 2008-2106

Results are more in line with what has been found for virtuous countries rather than for
southern ones: smaller coefficients, since less pervasive reforms were needed in order
to reassure markets, but more statistically significant, i.e. stable political majorities
usually succeed in managing financial uncertainty. This is an important result for
eastern European countries: although they had been under communist regimes until
1989, today their political systems prove to be efficient enough to stabilize public
finances, almost as countries as Austria and the Netherlands. Comparing
Sqrt(Share_Seats*volatility) coefficients with the ones in Table 7 we observe that,
after two decades since the abandoning of a dysfunctional economic planning, very
few remains make government action only slightly less incisive on spread than in two
of the most stable countries in the eurozone.
This result suggests that at least two post-soviet countries managed to establish
modern and well-functioning institutions, an essential prerequisite for becoming
performing markets (Fabry and Zeghni 2008). This is confirmed looking at estimates
on the quality of institutions and social capital:

Institutions Eastern Europe

Country Institutional Strength Legal Protection Absence of

Corruption
Poland 0.83 0.48 0.29
Czech Republic 0.83 0.58 -0.26
Mean 0.83 0.53 0.02

Social Capital Eastern Europe

Country Trust- Political Trust in Generalized

worthiness Engagement Institutions Trust
Poland 36.0 6.1 14.6 1.2
Czech Republic 35.2 6.4 13.1 1.2
Mean 35.6 6.25 13.85 1.2

Poland and the Czech Republic show a quality of institutions halfway Mediterranean
countries and northern ones. About social capital, they perform even better than
Austria and the Netherlands in Trustworthiness and Political Engagement, while they
show scores similar to the ones of Mediterranean countries in Trust in institutions and
Generalized Trust. Overall, they have reached a remarkable level in all considered
areas.

A useful insight is that governments of developing countries can become as efficient

as the best examples in the western world in dealing with crisis, if they manage to
follow a path of stable modernization of institutions a few decades long.
Consociationalist form of government

A last inquiry which our sample allows us to perform is to measure how political
variables change their weight in peculiar institutional contexts.

A form of government typical of some European countries is the consociational

democracy. In this kind of democracy compromise between parties is particularly
important, as Arend Lijphart, father of the term, suggests speaking about the
Netherland political system:

Society is divided into different and rather closed social groupings the
divisions are based on religious and class cleavages The blocs live side by
side, as distinctly separate subcultural communities, each with its own political
and social institutions and with interaction and communication across bloc
boundaries kept to a minimum [although] Dutch society is at least as much
divided as other continental societies, it has maintained a stable and viable
democracy The leaders of the blocs must be willing to bridge the gaps between
the mutually isolated blocs and to resolve serious disputes in a largely non-
consensual context. (The Politics of Accommodation, 1968, pp. 58 & 104)

The government must thus appeal to contending parties to accommodate their

differences in order to maintain the systems persistence.

Typical examples of states adopting this form of government are the Netherlands,
Belgium, Lebanon and South Africa. Since two of this are located in Europe and are
included in the sample, we can try to understand if such countries differ from others
when it comes to governments dealing with crisis.

The analysis of the effects of political variables in such context is particularly

interesting, suggesting that peculiar national features might heavily influence the
impact of political variables, and thus implying that the institutional context must always
be highly regarded while dealing with different national situations.
 Variable name Vol_index:CISS Vol_index:CISS Vol_index:VIX Vol_index:VIX
No controls With controls No controls With controls
Sqrt(Share of Seats) 5.6 106.0 663.0 596.0
(199.4) (196.4) (429.5) (377.4)
Parties in Parliament 1.0 0.1 -28.4 -43.9
(7.2) (7.0) (15.6)* (13.9)***
Parties in Government 21.0 19.0 25.5 33.9
(4.0)*** (4.0)*** (9.8)** (8.7)***
Sqrt(Share_Seats*volatility) 618.8 554.8 -79.5 -1.5
(664.2) (661.5) (99.7) (89.1)
Parties_Parliament*volatility 414.4 392.8 4.2 4.5
(41.0)*** (40.7)*** (0.7)*** (0.6)***
Parties_Government*volatility -190.1 -182.3 -1.3 -2.0
(40.4)*** (40.1)*** (0.5)** (0.5)***
Caretaker 13.8 52.0
(8.7) (9.9)***
Unemployment Change -20.3 -15.6
(9.5)** (11.5)
Number of observations 200 200 200 200
R (within)
2
0.95 0.95 0.91 0.93
Table 11: Consociational Countries, 2008-2016

One feature which emerges from the results is that, unlike in most other regressions,
a higher number of parties in the parliament has a particularly negative effect on its
room of maneuver in a crisis20. This is a direct consequence of the fact that Belgium
and the Netherlands are consociational republics, where representatives of different
components of society have a sort of veto power and thus have a greater bargaining
power, should reforms be enacted: the more parties are there in the parliament, the
more veto players must be listened to. The other feature is that the number of parties
forming the government has a positive effect on public finances, unique case among
all regressions. Since parties must deal even with those ones which do not form the
government, including such political forces in the government seems to reduce
disagreements when economic reforms are necessary to reassure markets (as Lijphart
himself states, in a consociational democracy pragmatism is necessary).

20
The non-significant effect of the share of seats is due to the fact that half of the sample is composed by
observations of Belgium, a country which performed particularly bad during the crisis from a political point of
view (reason why it is not considered a virtuous country and has been excluded from the North-South
partition)
Consociational countries are the only kind of countries in which wider coalitions have
irrelevant coordination costs. Actually, coalitions seem to even reduce such costs.

Other tests on the two countries singularly considered21 show that in Belgium the
negative effect of more parties in parliament is greater than in the Netherlands. This
suggests that ethnic contraposition might worsen the problem: unlike the Netherlands,
Belgium also faces the problem of three cultural groups (Flanders, Wallonia and
German-speaking community) which perceive themselves as very distant from each
other (Billiet, Maddens & Frognier 2006). This increase in contraposition between veto
players probably exasperates the decisional process in times of crisis.

Empirical findings and implications

In this paper, we investigate whether variations in the political scenario affect

creditworthiness of European Union member states. Building on a novel dataset based
on the ParlGov database by Dring and Manow (2016) and combining information on
political variations and economic performance for ten European countries over the
period 2001-2016, we show that the political situation of a country affects markets
decisions in financing public debt. The limited number of countries is a necessary
(although surely significant) drawback in order to deal with an organic sample (i.e.
European countries sufficiently relevant so that financial markets are aware of national
political situations).

Empirical evidence confirms the hypothesis that a greater majority in the parliament
allows to act more effectively in times of crisis with respect to a weaker majority; a
government which can avoid the risk that its bills will not pass seems more likely to be
able to convince markets of the sustainability of its public debt. A higher number of
parties in coalition governments does weaken sensibly the behavior of the majority in
periods of high volatility because of dealing costs between negotiators harming policy
outcomes. The number of parties in parliament instead does not affect much the
conduct of the majority and usually has no sensible effect on spread.

21
With the same procedure used on single Mediterranean countries, adding the volatility index as a pure
variable since time fixed effects could not be used
Still, there are various elements which seem to influence the impact of political
variables and which should be considered when evaluating the situation of a countrys
public finances:

- The belief of a supranational guarantee seems effective in avoiding liquidity

crisis, yet it also minimizes the impact of political variables. In fact, such
insurance encourages the political class to avoid dealing with problematic
situations: there is a trade-off between short run savings on interests and long
run savings coming from a sustainable management of public finance. This
trade-off should not lead to irresponsible behavior.
- For countries whose public debt is perceived as unsustainable as southern
European ones related to northern European ones it is more important to have
a stable government, since more pervasive reforms are required to reassure
markets than for a country which debt is seen as easily manageable. For the
same reason, instability in these countries is highly negatively regarded. Yet,
the actual impact of government action seems to depend on the quality of
institutions and on social capital.
- When smaller countries become target of financial speculation, politics seems
confirmed to be less effective. This is likely correlated to intrinsic characteristics
of small economies: a weaker background, less diversification, higher foreign
trade risk, and difficulties of (eventually) being part of an over-national union.
- Modernization processes of a countrys institutions result in great benefits when
it comes to the effect of politics on the economy, and allow to eliminate a great
share of residuals of past dysfunctional institutions. In the medium run, the
intervention of politics can become an instrument for achieving sensible savings
on interests on public debt in times of crisis. Although such modernization
processes might be traumatic, they allow to reach a level of institutional
development comparable to the one of modern central Europe.
- The impact of political variables might change radically in different institutional
frameworks: in consociational countries the number of parties in the parliament
is a feature which should not be overlooked, while the number of parties forming
the government seems to have a beneficial effect on economic policy outcomes,
in contrast with what happens in the rest of Europe.
It is therefore advisable, for a country which depends largely on financing from markets,
to provide itself with modern and well-functioning institutions, which should ensure
stable majorities and reduce requirement of coalitional governments. Instead, possible
issues posed by a more or less fragmented opposition should not be overestimated,
at least from the point of view of public finances. Still, specific characteristics of internal
political systems and of the international background must always be considered
closely, since they can heavily influence the scenario.
 Appendix

The volatility of the exchange rate with the Euro between 2000 and 2016 has been low
for eastern european currencies, expecially in the short run.

Euro/Zloty Exchange Rate

Euro/Czech Crown Exchange Rate

Euro/USD Exchange Rate

Euro/Yen Exchange Rate

In 2010 the financial crisis hit Europe more violently that before. In fact, considering
only the following period solves the problem of Sqrt(Share_Seats*volatility) with a
positive coefficient from table 4, where the regression also considered 2008 and 2009.

Eurozone 2010 2016

Variable name Vol_index:CISS Vol_index:VIX

Sqrt(Share of Seats) 1925.4 1384.9
(607.0)*** (1291.7)
Parties in Parliament 28.6 26.7
(6.8)*** (12.2)**
Parties in Government -27.3 -51.6
(18.0) (30.6)*
Sqrt(Share_Seats*volatility) -5593.6 -288.5
(1596)*** (283.3)
Parties_Parliament*volatility -273.3 -1.2
(45.9)*** (0.6)*
Parties_Government*volatility 277.7 3.0
(108.5)** (1.5)*
Caretaker -5.8 -8.8
(46.0) (45.8)
Unemployment Change 290.4 306.5
(41.9)*** (42.9)***
Number of observations 664 664
R2 (within) 0.46 0.44

European Union 2010 2016

Variable name Vol_index:CISS Vol_index:VIX

Sqrt(Share of Seats) 161.5 731.3
(215.5) (470.3)
Parties in Parliament 17.8 23.1
(5.6)*** (9.5)*
Parties in Government 7.5 -40.5
(13.5) (23.5)*
Sqrt(Share_Seats*volatility) -1375.8 -196.2
(700.0)** (104.9)*
Parties_Parliament*volatility -191.2 -1.1
(37.1)*** (0.5)**
Parties_Government*volatility 133.9 3.1
(86.5) (1.2)**
Caretaker -18.5 -1.5
(40.8) (40.4)
Unemployment Change 293.5 304.0
(36.2)*** (36.4)***
Number of observations 830 830
R2 (within) 0.42 0.41
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