Monday, October 31, 2011

Credibility is not everything

by Paolo Manasse


October 31, 2011

Many have argued in recent months that the Eurozone’s emergency meetings should be about restoring credibility, with a ‘big bazooka’ or otherwise. This column looks at Italy, a country financiers are fast turning their back on. It argues however that the problem is Italy’s fundamentals – not its credibility.

Many observers of the European debt crisis have embraced the idea that ​the dangers, in particular the risk of default of Italy, lie in the possibility of ‘multiple equilibria’. According to this view, when economic fundamentals, such as the debt/GDP ratio and the primary balance, are not quite ‘as good’ as to guarantee solvency but not quite ‘as bad’ as to make the country plainly insolvent, then the equilibrium outcome depends on market expectations (see for example Alesina et al 1989). In other words, self-fulfilling prophecies may generate opposite and unpredictable outcomes, for the same level of fundamentals. If the market assigns a high probability to a default, it will require a very high risk premium in order to buy governments bonds, making it convenient (or unavoidable) for the government to default, rather than risk strangling the economy in order to generate the surplus required to repay the loan (bad equilibrium). Whereas, if markets are confident in the government’s ability and/or willingness to repay, the low yields will generate the right incentives for the government to fulfil the market expectations (good equilibrium). This gives rise to the idea that ‘credibility is everything’.

One corollary of this approach, at the European level, is that unless the EFSF has sufficient firepower to fight off a speculative attack, say €3 trillion, it may not prevent a rollover crisis stemming from a shift in market expectations. Another corollary, relating to the Italian case, is that a sufficient condition for saving Italy is for Mr Berlusconi, who has lost international credibility, to step back. I argue here that this latter condition, while possibly being necessary at this stage, is unlikely to prove sufficient. Market fundamentals are, unfortunately, still decisive.


See an updated version here

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