Two-level games and market constraints on politics in Europe
| DOI | 10.1177/0192512120924032 |
| Published date | 01 January 2022 |
| Date | 01 January 2022 |
| Subject Matter | Articles |
https://doi.org/10.1177/0192512120924032
International Political Science Review
2022, Vol. 43(1) 136 –153
© The Author(s) 2020
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DOI: 10.1177/0192512120924032
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907925IPS0010.1177/0192512120924032International Political Science ReviewMcMenamin et al.
research-article2020
Article
Two-level games and
market constraints
on politics in Europe
Iain McMenamin
Dublin City University, Ireland
Michael Breen
Dublin City University, Ireland
Juan Mu~
noz-Portillo
University of Costa Rica, Costa Rica
Abstract
Financial markets understood the Euro crisis as a two-level game. They monitored national
politics as a source of both national and European policy. The incentives to conform to the
market’s preference were weaker for creditor countries than for debtor countries because
debtors were providers of their own macroeconomic policy,but each creditor was one of several
contributing to bailouts. Worries about default caused investors to sell the bonds of debtors and
thereby constrained debtors by raising interest rates. By contrast, if creditor behaviour reduced
the probability of a bailout of debtors, the response again would be to sell assets linked to the
debtor. The implication is that market responses to creditor elections should have been larger
and more turbulent than reactions to debtor elections. We test this theory by analyzing credit
default swaps of eleven countries around fifteen elections and conducting a content analysis of
3,126 reports from Bloomberg terminals.
Keywords
Elections, international political economy, financial markets, Germany, Euro crisis
Corresponding author:
Iain McMenamin, School of Law and Government, Dublin City University, Collins Avenue, Dublin D09 Y5N0, Ireland.
Email: iain.mcmenamin@dcu.ie
McMenamin et al. 137
I think that’s the irony of every time we got some Euro crisis speculations back in markets, there
is one big beneficiary, and that’s the German economy. (Carsten Brzeski, Chief Economist,
ING-DIBA, commenting on Italian government formation on Bloomberg TV, 30 May 2018)
Introduction
In the context of national politics, the financial market can send signals to political systems
about its preferred policies. Indeed, these signals comprise an incentive structure so
strong that many perceive it as a constraint on the choice of national macroeconomic
policy. The Euro crisis was a two-level game (Putnam, 1988). The financial market moni-
tored national politics as a source of national policy and as a source of European policy.
The market sent signals about its preferred policies at both levels. However, market reac-
tions only incentivised conformity to the market’s preferred policies in debtor countries,
where national macroeconomic policy was of most relevance to the Euro crisis. In the stable
creditor countries, international policy, specifically positions on bailouts, were more salient
than national macroeconomic policy. Markets were able to signal their preference for EU
bailouts but were not able to constrain creditor countries from advocating much lower levels
of support than markets preferred. Consistent with this, we show that market reactions to
creditor elections during the Euro crisis were larger and more turbulent than reactions to
debtor elections. We argue that the incentives to conform to the market’s preference were
weaker for creditors than debtors because debtors were providers of their own macroeco-
nomic policy, but each creditor was one of several contributing to bailouts. Worries about
default caused investors to sell the bonds and related financial instruments of debtor coun-
tries. This meant they could constrain debtors in the short term by raising interest rates.
The constraint on creditors was indirect and not immediate. If creditor behaviour reduced
the probability of a bailout of debtors, the response again would be to sell assets linked to
the debtor. Higher interest rates on assets linked to debtor countries raised the probability of
financial and economic instability that was likely to damage creditors in the medium to long
term. In the short term, worried investors might even swap the troubled bonds of debtors for
the safe bonds of creditors, thereby actually reducing the debt-servicing costs of the cred-
itors. Democratic governments have time horizons of years; politicians in an election cam-
paign have time horizons of weeks. During election campaigns, the pressure on creditor
politicians to maintain commitment to bailouts was particularly weak.
In international negotiations, leaders’ moves in the international arena interact with their
moves in the national political arena. A move at one level is a move on the other. Eurozone
bailout negotiations were focused on the dimensions of solidarity (loans for countries in
trouble) and austerity (spending cuts and tax increases in troubled countries). We concen-
trate on elections, the crux of domestic political competition. Both dimensions offered vote-
winning opportunities to politicians of all parties across the EU (Raunio, 2016: 245).
However, these opportunities were constrained to different extents in debtor and creditor
countries. Politicians in debtor countries were aware of the immediate and drastic conse-
quences their statements could have (Ruiz-Rufino and Alonso, 2017: 322). Politicians in
creditor countries did not fear immediate consequences for their electorate.
In order to test our theory, we need to measure how markets reacted to elections. We do
so by looking at credit default swaps (CDS), which insure against default and were, there-
fore, the assets most closely linked to the core issue of the Euro crisis (Brooks et al., 2015:
2International Political Science Review 0(0)
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