You are neither dumb, nor stupid, Paul…


The „illiquid but solvent / self-fulfilling“ (SF) argument says that when solvency concerns lead to rising yields, this in turn undermines the sustainability of the debt, leading to yet another increase in yields, etc. Solvency concerns (or speculation in this direction) become self-fulfilling in this case. This argument is intuitive and under certain assumptions correct. Karl Smith actually applied for the title of „most detached econblogger“ because he found it to be too obvious to write much about it.

However, the key assumption for multiple equilibria is that the true probability of default is in a certain range in which both equilibria are possible. It doesn’t say that every default is the result of a self-fulfilling dynamic. Contrary to many proponents in the German press, Paul is of course aware of that (emphasis mine):

The point, however, is that Italy and Spain arguably are at risk of suffering from self-fulfilling panics. And you need open-ended credit to avert that fate.

And in an earlier post on the subject, he writes:

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.

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth. Some people made the SF argument in 2010 for Greece – a politically and institutionally weak country with ridiculous recent inflation dynamicstrapped in a currency union with macroeconomically prudish countries like Germany and a stubbornly suicidal ECB. That was obviously wrong, and in my view not only in retrospect. For Portugal, the verdict is not in yet, but as my guest blogger Henry Kaspar pointed out, it doesn’t look good; for Ireland it looks much better now.

For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging. If a country is credibly committed to re-gaining competitiveness, and it has the political institutions to succeed, there is every reason to start unlimited liquidity support to prevent a self-fulfilling panic. If it can’t (like Greece) or is reluctant to (like Italy?!), then what looks at first like a self-fulfilling liquidity-turned-solvency problem is in fact a garden variety solvency problem, and should be treated as such: support, yes, but with heavy conditionality to turn it into a liquidity problem.

As Henry Kaspar writes:

[L]iquidity support should be conditional – conditional on credible assurances, or even better: demonstrated behavior to do what it takes to improve competitiveness and remain solvent. Any liquidity provider – be it the ECB, or the EFSF, or Germany – is perfectly right to insist on this. Unconditional liquidity support provokes unsustainable behavior, and therefore risks undermining the sustainability of the euro area instead of promoting it.

Exactly. So don’t blame Germany alone (unless you are talking about monetary policy) for a political mess that is founded to an underappreciated extent on other countries’ unwillingness to aggressively restore competitiveness.

PS: I should also point out that my presentation of Germany and its internal devaluation between 1998 and 2006 was not meant as a „look how good we are“ example, but more as a „damn that was hard“ example for why I am sceptical that Italy and Spain are solvent, let alone Portugal or even Greece.

PPS: See also Ryan Avent’s response to Henry’s post.