Institute for International Economics
July 20, 2011
With Italian and Spanish 10-year bond rates still at record highs, despite the new Italian austerity budget approved over the weekend, it is evident that the markets are telling EU policy makers to fix the debacle over "private sector involvement" (PSI) in the second Greek bailout.
At the heart of the current fiasco is the demand by euro area leaders that financial institutions and other creditors share the burden with taxpayers for financing Greece for the next couple years. This demand would effectively reverse the EU leaders’ promise in 2010 to consider PSI only after 2013 and in no program under current consideration. More important, the demand for sacrifice from creditors would set a precedent for private investor haircuts as part of rescue packages for countries facing liquidity problems, 1 not official sector insolvency.
This distinction is critical. A precedent of imposing sacrifice on private creditors for illiquid countries will inevitably threaten the risk-free status of all peripheral euro area countries, leading to a generalized reevaluation of risk levels in Europe.
The failure to resolve the Greek crisis, coupled with the political demand for a Greek PSI, has unleashed a contagion that has become a kind of slow-motion version of the first vote against the Troubled Asset Relief Program (TARP) in the US House of Representatives in October 2008. In that instance, the initial rejection by lawmakers caused the single largest daily stock market decline of the 2008–09 financial crisis.
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