This exchange between Wolfgang Munchau and Iain Begg provides an interesting counterpoint to my weekend analysis of the Euro sov debt crisis. My post first discusses the theory behind “bazookas” as a means of preventing or deterring runs against sovereign debt (and a similar analysis holds with respect to banks too). I then point out that the credibility of the bazooka/backstop is of crucial importance.
Begg’s reply to Munchau sets out the bazooka theory. Munchau’s argument is that the EFSF bazooka is not credible. It is not credible primarily because is based on the premise that countries like Italy will fund it, but countries like Italy are causing the problem too. That is, the EFSF is beset with wrong way risk. The Europeans are in effect aiming the bazooka at their own heads. That isn’t the most credible deterrent against runs.
Indeed, the structure is highly unstable. If, say, Italy can’t perform on its obligations because it is the one being bailed out, that increases the burden on France, which could put France into jeopardy.
I generally agree with Manchau. Biggs has it right when it comes to how a backstop can prevent liquidity crises, but that backstop has to be credible: I agree with Manchau that the EFSF mechanism is not credible, given its wrong way risk problem.
Taking things to the next level, as I did in my post: what is the likelihood of negotiating a credible mechanism? Here I am again skeptical, for political economy reasons, as expressed in the post. On this issue, I was intrigued to see two posts touching on this issue in general. Tyler Cowen dismisses IS-LM in part because it ignores altogether political economy issues, which he identifies as a first-order macroeconomic factor. I agree completely. Indeed, it is kind of bizarre to discuss sovereign debt crises, banking crises in which there was a strong regulatory dynamic, and fiscal crises (all components of Financial Crisis I and II) without discussing political economy. Peter Boettke follows up on Tyler’s post, and emphasizes the centrality of political economy to macro problems, and in particular macro policies.
I agree that political economy is the linchpin, and not just in macro policy but all of the regulatory issues that are currently of pressing importance. The reason that I am quite concerned about Europe is precisely because political economy issues there make it very difficult to devise a mechanism for allocating sovereign debt losses (and potential banking losses connected thereto). It is always hard to devise such sharing mechanisms, particularly after a chunk of the losses has already been realized. It is even harder given the institutional structure of the EU, which by design makes it difficult (and arguably illegal) to shift losses on one state’s debt to other member states.
You will hear many plans of bazookas in coming weeks. All will differ in details. What you should focus on is whether these mechanisms are in fact credible, and politically feasible. The things we’ve seen so far, not so much–as Manchau emphasizes. Incredible political creativity–and perhaps, duplicity–will be required to create a credible mechanism. The economic destination is pretty well understood, but the political road to get there is unmapped, and indeed, is likely yet to be built.