The Perverse Politics of Financial Crisis

by Luigi Zingales

Project Syndicate
July 25, 2011

In trying to understand the pattern and timing of government interventions during a financial crisis, we should probably conclude that, to paraphrase the French philosopher Blaise Pascal, politics have incentives that economics cannot understand.

From an economic point of view, the problem is simple. When a sovereign borrower’s solvency has deteriorated sufficiently, its survival becomes dependent on market expectations. If everybody expects Italy to be solvent, they will lend to Italy at a low interest rate. Italy will be able to meet its current obligations, and most likely its future obligations as well. But if many people start to doubt Italy’s solvency and require a large premium to lend, the country’s fiscal deficit will worsen, and it will most likely default.

Whether a borrower like Italy ends up in the lap of good expectations or tumbles into a nightmare scenario often depends upon some “coordinating news.” If everyone expects that a credit-rating downgrade will make Italian debt unsustainable, Italy will indeed default after a downgrade, regardless of the downgrade’s real economic effects. This is the curse of what we economists call multiple equilibria: once I expect others to run for the exit, it is optimal for me to run as well; but if everybody stays put, I have no interest in running.

Given this economic dynamic, there seem to be two obvious policy prescriptions. First, it is too dangerous for any country to come even remotely close to the point where insolvency can be triggered by a sunspot. While nobody knows exactly what this danger level is, it is clear where the alarm starts to arise. Given the enormous cost of a default, any government should stay far away from the danger zone.

The second prescription assumes that if, for any reason, a country does end up in the danger zone, only two responses make economic sense. Either officials recognize immediately the inevitability of default and waste no resources trying to prevent it, or they believe that a default can be avoided and deploy all the resources at their disposal as fast as possible. As in many wars, a staged escalation in a financial crisis often leads to the worst possible outcome: a defeat with large losses.

More