A Self-Fulfilling Euro Crisis? (Wonkish), by Paul Krugman, in NY Times: The big question, I believe, is whether the Italian and maybe Spanish crises are the kind of thing that might be brought under control by ECB bond purchases. This is often phrased in terms of whether they are facing liquidity or solvency problems; but I think it’s better phrased in terms of the possibility of self-fulfilling crises, a la Obstfeld. (Obstfeld was thinking of devaluations in a fixed-exchange-rate system, but the logic also applies to default within a single currency).
In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.
In the Italian case, you have big debt but also a primary budget surplus. So if interest rates stayed low, as they would if no default were expected, it wouldn’t be hard to service the debt with only modest further fiscal adjustment.
But if people expect a default – and also if they believe that once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors – then you could see interest costs rising to a point where default indeed becomes the preferred option.
So there is a reasonable case that what we’re seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that’s exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn’t needed. It’s certainly worth a try.
While I’m at it, a further note: a country with the same level of debt as Italy, but with its own currency – and with debt in its own currency – would not face the same kind of crisis. The temptation, after all, would be to inflate rather than to default – and inflation does not have the same kind of “first bite of the cherry” aspect that default has, in which once you’ve decided to move you might as well impose a 50 percent haircut or thereabouts on creditors. What this means, I believe, is that a country with its own currency would not be subject to the kind of self-fulfilling panic that is now arguably hitting Italy. I leave the relevance of this observation to other parties as an exercise for readers.
Update: Via Calculated Risk, here it comes. I think this is confirmation, although the Eurospeak is so thick I’m not entirely sure what they said. But as you may have gathered from the discussion above — or am I equally incomprehensible? — I’m for it. It’s risky, but not acting would be fatal for sure.