Financial Markets and Public Finance

Neue Studien zur Politischen Ökonomie 10 Erik R. Fasten Financial Markets and Public Finance Sovereign Risks, Credit Markets and Fiscal Federalism Nomos

Die Reihe Neue Studien zur Politischen Ökonomie wird herausgegeben von Prof. Dr. Charles B. Blankart Prof. Dr. Reiner Eichenberger Prof. Dr. Lars P. Feld Prof. Dr. Dr. h.c. mult. Bruno S. Frey Prof. Dr. Gebhard Kirchgässner Prof. Dr. Dr. Christian Kirchner Prof. Dr. Dr. h.c. mult. Friedrich Schneider Prof. Dr. Alois Stutzer Prof. Dr. Hannelore Weck-Hannemann Band 10

Erik R. Fasten Financial Markets and Public Finance Sovereign Risks, Credit Markets and Fiscal Federalism 2.Auflage Nomos

Gedruckt mit Unterstützung des Förderungs- und Beihilfefonds Wissenschaft der VG Wort. Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http://dnb.d-nb.de abrufbar. Die Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the Internet at http://dnb.d-nb.de. Zugl.: Berlin, Humboldt-Univ., Diss., 2010 ISBN 978-3-8329-6579-2 1. Auflage 2012 Nomos Verlagsgesellschaft, Baden-Baden 2012. Printed in Germany. Alle Rechte, auch die des Nachdrucks von Auszügen, der fotomechanischen Wiedergabe und der Übersetzung, vorbehalten. Gedruckt auf alterungsbeständigem Papier. This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically those of translation, reprinting, reuse of illustrations, broadcasting, reproduction by photocopying machine or similar means, and storage in databases. Under 54 of the German Copyright Law, where copies are made for use other than private use, a fee is payable to»verwertungsgesellschaft Wort«, Munich.

Contents 1 Introduction 17 2 Sudden Death or Glorious Convalescence: Risk Transfers, Cross-country Spillovers and Sovereign Defaults 19 2.1 Introduction 19 2.2 Related Literature 20 2.3 Theoretical Motivation 22 2.4 Fiscal Positions and Default Risks 25 2.4.1 Cost of public debt in the euro area 26 2.4.2 Market-based implicit default probabilities 28 2.5 Channels of Risk Transfers 33 2.5.1 Primary data set 35 2.5.2 Risk transfer from the private to the public sector 36 2.5.3 Cross-country spillovers 37 2.5.4 Implications of the results 41 2.6 Conclusion 44 3 On the Sustainability of sub-national Government Finance A Panel Data Approach 47 3.1 Introduction 47 3.2 Theoretical Concepts and Related Literature 47 3.2.1 Role of Public Debt 48 3.2.2 Devolution tendencies 54 3.2.3 Institutions to contain indebtedness 58 3.3 Empirics 62 3.3.1 Data Description 63 3.3.2 Econometric Models and Results 66 3.3.3 Static Analysis 66 3.3.4 Dynamic Analysis 69 9

3.4 Application to Germany 70 3.5 Conclusion 75 4 Two-sided Certification: The market for Rating Agencies 77 4.1 Introduction 77 4.2 Related literature 78 4.3 The Setup 79 4.4 Optimal behaviour of a monopolistic certifier 81 4.4.1 The market without the certifier 81 4.4.2 One-sided certification 83 4.4.3 Comparison of one-sided certification 88 4.4.4 Two-sided certification 90 4.5 Application to the Rating Market 95 4.6 Conclusion 100 5 The Fiscal-Financial Transmission Channel: Asset pricing in Germany 103 5.1 Introduction 103 5.2 Related Literature 104 5.3 Taxation 107 5.3.1 Construction of the Effective Marginal Tax Rate 108 5.3.2 Application to the German Tax System 110 5.3.3 Effective Marginal Tax rate in Germany 115 5.4 Empirics 116 5.4.1 Macroeconomic Environment 116 5.4.2 Estimations and results 118 5.5 Results and Transmission channel 123 5.6 Conclusion 124 6 Conclusion and Discussion 127 A Appendix: Sudden Death or Glorious Convalescence: Risk Transfers, Cross-country Spillovers and Sovereign Defaults 133 A.1 Computation of market-implied default probabilities 133 10

A.2 Stylised sovereign balance sheet 134 A.3 Sources of risk for the public balance sheet 135 A.4 Financial market rescue measures: Direct impact 136 A.5 Financial market rescue measures: Contingent liability 137 A.6 Risk-neutral default probabilities compared to rating assignments 138 A.7 Standard deviation of default probabilities of selected Euro area countries 139 A.8 Key variables applied in the panel estimations 139 A.9 Exposure of banks in sample countries 140 B Appendix: On the Sustainability of sub-national Government Finance APanel Data Approach 143 B.1 Institutional rules and deficits 143 B.2 Empirical results 144 C Appendix: Two-sided Certification: The market for Rating Agencies 145 C.1 Summary results 145 C.2 Appendix Proofs 146 C.2.1 Proof of Proposition 4 146 C.2.2 Proof of Lemma 1 146 C.2.3 Proof of Lemma 2 146 C.2.4 Proof of Proposition 5 146 C.2.5 Proof of Lemma 3 147 C.2.6 Proof of Lemma 4 147 C.2.7 Proof of Lemma 5 148 C.2.8 Proof of Proposition 6 148 C.2.9 Proof of Corollary 6 149 C.2.10 Proof of Lemma 8 149 C.2.11 Proof of Lemma 8 149 C.2.12 Proof of Lemma 9 149 C.2.13 Proof of Lemma 10 150 C.2.14 Proof of Proposition 7 151 11

D Appendix: The Fiscal-Financial Transmission Channel: Asset pricing in Germany 153 D.1 Construction of the effective tax rate 153 D.2 Differences of the imputation systems: full imputation system 154 D.3 Differences of the imputation systems: half income system 155 D.4 Sources of variables 156 D.5 Price-Earnings Ratios in Selected Countries 157 Bibliography 159 12

List of Figures 2.1 Public debt in selected OECD countries 1970-2010 27 2.2 Sovereign yield spreads over German bund between 1 July 2007 and 31 August 2009 28 2.3 Budget balance and sovereign yield spreads during the crisis 29 2.4 Potential spillovers to public balance sheets 34 3.1 General government gross financial liabilities in selected advances economies from 1970 to 2011 52 3.2 Devolution tendencies in selected OECD countries between 1980 1) 2003 2) 55 3.3 Deficit per revenue ratio for all countries from 1980 to 2005 64 3.4 Sovereign debt and deficits in Germany between 1970 and 2009 73 4.1 Market outcomes without a certifier 82 4.2 Quality threshold q 83 4.3 Profit shares with one-sided seller-certification 89 4.4 Difference of seller segmentation with one- and two-sided certification. 90 4.5 Profit shares with two-sided certification compared to one-sided. 99 5.1 Transmission Channels of Fiscal Policy 104 5.2 Investors, Institutions and Asset Prices 106 5.3 The Size of the States 107 5.4 Shareholder Structure in Germany between 1972 and 2006 113 5.5 Marginal income Tax Rates in Germany between 1958 and 2005 shareholder structure in Germany between 1972 and 2006 114 5.6 Shareholder Structure in Germany between 1972 and 2006 115 5.7 Effective Marginal Tax Rate in Germany 1973-2006 116 5.8 Economic Environment in Germany between 1973-2006 117 5.9 Cointegration Graph 123 13

List of Tables 2.1 Historical recovery rates of selected sovereigns 31 2.2 Default Probabilities derived from bonds spreads 33 2.3 Static estimation results: Transfer of private risks 38 2.4 Dynamic estimation results: Transfer of private risks 39 2.5 Static estimation results: Cross-country spillovers 42 2.6 Dynamic estimation results: Cross-country spillovers 43 3.1 Summary Statistics 65 3.2 Classification of Institutional Differences 65 3.3 Empirical results for OLS and GLS 68 4.1 Bidding behavior of buyers with seller-certification 86 4.2 Bidding behavior for the case of two-sided certification 91 4.3 Moody s yearly revenues and revenue shares depending on sales scheme 97 5.1 Overview on the variation of the corporate income tax in Germany 111 5.2 Results of Unit root tests 119 5.3 Granger-Causality-Test for the effective marginal tax rate and price-earnings (price-dividend) ratios 120 5.4 Cointegration Test Results for Price-Earnings Ratio (Maximum Eigenvalue) 121 5.5 Cointegration Test Results for Price-Earnings Ratio (Trace) 121 5.6 Normalised Johansen Cointegrating Coefficients; Stock response to innovations in macro variables 122 14