Wonking Out About the Euro Crisis (Very Wonkish), by Paul Krugman, in NY Times: Update: Paul DeGrauwe made a similar argument several months ago, with a lot of supporting evidence.
Here’s how I think of what may be going on in Europe right now. Imagine that markets are trying to put a probability on default. And they believe that if default takes place at all, it will involve serious losses to bondholders. Why? Because there’s a crossing-the-Rubicon aspect to default: once a government does it, it’s going to pay serious reputational costs, so it might as well get significant debt relief while it’s at it.
Meanwhile, the decision to default involves weighing the pain from default against the pain of trying to pay debt in full — and the latter depends among other things on the interest rate. A sufficiently high interest rate will make the burden of debt unbearable, and trigger default.
So you get a picture something like this:
Suppose we ask what rational expectations would imply — I know, I know, but rational expectations is a useful gadget for clarifying your thoughts as long as you don’t take it too seriously. And in this case, what RE implies is that there are two equilibria. Equilibrium A is where investors don’t believe you will default, so interest rates are low, so you don’t. Equilibrium B is where investors believe you will, so rates are high, so you do.
The story for Italy, then, is that events in other countries have threatened to push the country to bad equilibrium B. And the ECB’s mission, should it choose to accept it, is to provide enough funding to rule that out and push the thing back to A.
Now, what would happen if Italy still had its own currency? There would be no need to default; if it wanted debt relief, it could inflate the real burden down. (France in the 1920s, which was one chapter in my dissertation, is a good example). Now, inflation is a bad thing in itself, or at least that’s what officials believe, so it would be undertaken reluctantly; we can think of a reaction function in which higher interest rates lead to higher inflation as a policy choice, but not one for one.
This gives us the following picture:
Here the market reaction is to raise interest rates one for one with expected inflation, while the government reaction is to raise inflation less than one for one with interest rates; this implies a unique rational expectations equilibrium. Again, I don’t seriously argue for rationality in everything, I’m just using it as an intuition pump.
What I come up with, then, is that there is a possibility of self-fulfilling crisis under the euro, in a way that wouldn’t arise with a national currency. And as I see it, that self-fulfilling-crisis argument is the justification for what the ECB is doing.