Last week’s tumult in Italian markets shows the eurozone crisis has entered a new and far more dangerous phase, proving that the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish not a policy.
No country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations’ burdens Keynes warned about in The Economic Consequences of The Peace.
Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates are likely to become insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland, and is in danger of happening in Italy and Spain. Continue reading »