The fundamental reasons behind the Euro-Zone sovereign debt crisis are well known. But, as with many crises, the common theme is uncertainty. Too many question marks remain about what action the ECB and Euro-Zone leaders will do to fix the situation in both the short- and long-term.
When uncertainty rises to a dominant level, agents in the economy begin to fear worst-case scenarios. Figure 1 gives a rough indication of the sudden increase in worst-case scenario fears with deflation, or Japanese-style deflation, being a scenario many people feared.
Figure 1: Shows the number of times “deflation” appeared in Google News stories.
In 2008, policymakers unveiled a raft of actions to address the illiquidity in the interbank markets and the solvency of banks. These actions helped to reduce the uncertainty in the markets, as policymakers acted to insure the banking system from collapse.
With food and energy prices remaining high, deflation is not currently feared but a Euro collapse is, see Figure 2.
Figure 2: Shows the number of times “euro collapse” appeared in Google News stories.
Fears of a Euro collapse have escalated in the last year and this is a worst case scenario. Investors effectively decide to maximize a set of of minimum (or worst case) outcomes (Gilboa and Schmeidler (1989)), i.e. making the most out of a bad situation, and in reality this can be seen by the flight-to-quality moves over the last four years into US and German government bonds, strengthening of the Swiss Franc and Japanese Yen as well as the rising gold price.
So, that’s what’s been happening but how does a policymaker address it?
Caballero (2010) describes how a financial crisis is like a heart attack. When a heart attack hits, medics use a defibrillator to send a sudden electric shock through the body to kick start the heart. But the longer the delay before the shock is administered, the harder it is to restart the heart. Applying this to the financial crisis basically means that a financial markets needed to be administered with a policy shock large enough and credible enough to improve confidence in political and economic leaders i.e. implementing policies that market participants believe in. The longer the shock is delayed, the harder it is to win the confidence of the markets and the bigger the shock is needed.
The broad description of the policy measure is government insurance. In this crisis, it means that market participants are insured from a Greek default or the collapse of a bank etc. In this respect it is similar to the classic bank run model Diamond and Dybvig (1983). By introducing this type of insurance, investors will return to these markets and the insurance may never have to be paid out.
If Greece is allowed to partially default on its debts, the banks exposed to Greece will have to be supported by governments to ensure their survival, therefore, this course of action would still be inline with the provision of insurance.
This, of course, is a simplistic summary and many other measures should be introduced to address the moral hazard issue of bailouts but the important point is to act to stop the continuing economic deterioration caused by the uncertainty Euro-Zone debt crisis.
Caballero, R., J. (2010). Sudden Financial Arrest. IMF Economic Review, July 20, 2010. http://econ-www.mit.edu/files/6010
Diamond, D., W, Dybvig, P., H. (1983). Bank Runs, Deposit Insurance and Liquidity. The Journal of Political Economy. Vol. 91, No. 3, pp. 401-419. http://econ.tu.ac.th/archan/wasin/EC431_1_51/Final_1_51/Bank_runs_Deposit_Insurance_and_Liquidity.pdf
Gilboa, I., Schmeidler, D. (1989) Maxmin Expected Utility with Non-Unique Prior. Journal of Mathematical Economics. Vol. 18, pp. 141-153. http://teaching.ust.hk/~bee/papers/040918/1982-Gilboa_Schmeidler-Maximin%20expected%20utility.pdf