Fiscal crisis, contagion, breakdown of the Euro... Let’s try to understand what is going on. In the past few days, the scenarios discussed in the media have been changing so rapidly and dramatically that for many it may be hard to grasp the reason behind them. But in emergencies such as the one we are currently experiencing, they way to escape the worse scenarios and find an exit strategy is stick to clear-headed thinking.

What happens when sovereign states pile up a large amount of debt?

First, investors start worrying that this debt may not be sustainable: concerns rise over the ability of the state to pay back capital and interests by generating budget surpluses in the future (that is, fiscal revenues in excess of expenditures). In this case, investors require higher interest rates to subscribe new public debt as a compensation for the risk of insolvency. This in turn increases the risk of insolvency as it worsens public sector balance sheets further. At some point there may no longer be an interest rate able to compensate investors for the risk of insolvency; then they just stop subscribing the public debt. This is a situation of fiscal crisis and has only two possible (and not mutually exclusive) outcomes: 1) government default followed by a renegotiation of the debt (as in Argentina’s case); 2) monetisation of the debt, which is effectively bought by the central bank. This represents an injection of money in the economy and thus generates inflation and exchange-rate depreciation.

From Greece to Italy

Second, in the case of Greece, the second option – monetisation - was ruled out by Greece’s membership in the European Monetary Union: the Greek government could not force the ECB to buy its own bonds. For this reason, the only option was insolvency and renegotiation of the debt, unless other countries were willing to lend to Greece at an interest rate lower than the market one. Why did Euro area countries choose to do so? In the past few days it has been clear that, following a substantial dose of indecision, they did it mainly for fear of “contagion”.

But what is contagion?

Here we come to the third and most interesting part of the story. As the Greek crisis unfolded, investors started to suspect that other countries with a high level of public debt, namely Portugal, Spain and Italy, would find themselves in a similar situation. But as governments of these countries rushed to point out, their fiscal position is not as dramatic as the Greek one.

So why are investors so concerned? Because, as economists say, in this game between sovereign states and investors there can be “multiple equilibria”. Even if the government is not highly indebted, investors might start questioning its willingness to raise taxes above a level considered as “politically sustainable”. In the future it might seek a renegotiation of the debt or its monetisation or both. Fear that this will happen can push interest rates to a level so high that the investors’ prophecy will eventually come true. At the prevailing interest rates a country which would have otherwise been able to service its debt ends up needing a renegotiation or a monetisation of the debt to avoid full repayment (see for example Calvo 1988).

So the outcome depends on investors’ confidence. If there is confidence, the “good equilibrium” with moderate interest rates and stable markets prevails; when confidence disappears, the economy jumps to a “bad equilibrium”, where a fiscal crisis occurs. The contagion generated by Greek crisis has been exactly of this type. It has weakened investors’ confidence in countries which would have otherwise been in a safe situation. Moreover, the burden of Greek bail-out itself is affecting negatively the fiscal position of Portugal, Spain, and Italy. This too may have contributed to weaken confidence in their ability to service the debt.

Continues at VOXEU.org

ABSOLUTELY EXCELLENT article!!