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A Behavioural Model of European Bond Markets

Bodo Herzog

This paper builds a new theory of euro area sovereign bond markets. The theory explains the anomalous bond pricing and increasing spreads during the ‘Euro-Crisis’. I show that the malfunctioning of euro area bond markets is triggered by asymmetric information and weak reputation in economic and fiscal policy. Both factors trigger a standard bond market to turn into turmoil. In the end, those markets are prone to self-fulfilling bubbles due to animal spirits. Consequently, mispricing of sovereign debt is inherent in the Eurozone and creates more macroeconomic instability than in a stand-alone country.