A number of media commentators have drawn a comparison between the present debt crisis and the ERM crisis of 1992/93. Then, the authorities assured markets there would be no devaluation; but the high interest rates needed to defend the peg against sceptical currency traders proved too painful and the government eventually succumbed. Today, sceptical markets are demanding a high risk premium to hold Irish bonds. There is concern that the pain of high interest rates and their impact on debt dynamics will, once again, make market expectations self fulfilling.
I believe it is a mistake to take this comparison too far. The combination of long average maturity, liquid reserves, and the back-ups of the NPRF/EFSF make a forced default in the short to medium run unlikely. Moreover, a cost-benefit calculation for sovereign default for a country that clearly has the capacity to repay suggests a voluntary default is also unlikely.
Even if the comparison is overblown, the lessons from the innovative models developed at the time to understand self-fulfilling currency crises are useful for understanding the current challenges (see, for example, Obstfeld, 1996). The crucial idea is to model the government’s objective function directly, recognising that it is engaging in a constant trade off of the costs and benefits of devaluation (or default). High interest rates increase the pain of a defence. At some point the pain becomes too great and a default ensues. Thus pessimism can be self fulfilling under certain conditions. The models also highlight that the government’s objective function – or more broadly the political capacity to engage in a painful defence of a currency (or creditworthiness) – is part of the fundamentals of the economy.
Reading yesterday’s papers and scanning the morning talk shows revealed a depressing willingness of many to jump to the perceived easy way out of sovereign default. (The distinction between sovereign borrowing/guarantees and non-guaranteed bank borrowing was often glossed over.) The prevalence of this seemingly relaxed attitude could be partly behind the market view that Ireland is not willing to do what it takes to pay its sovereign debts. Again, I think this perception is mistaken. But it does suggest a need to shore up the reality and perception of our political capacity to avoid default, a capacity that is no less part of the fundamentals than the size of the bank losses or the expected growth rate.
Some possible capacity building measures:
· Emphasise the bright line between sovereign default on debt/guarantees and choosing not to bailout non-guaranteed creditors of insolvent banks.
· Recognition that a well-specified multi-year budget is essential to regain fiscal credibility, but is also political dynamite. While opposition parties are understandably looking to force a general election, a degree of cooperation on the broad parameters of the deficit reduction – including a willingness to specify the main details of any alternative package – would enhance perception of the political capacity to put the deficit on a “convergent path.” The stakes are too high to approach deficit policy purely in terms of party political advantage.
· An accelerated move to put in place an independent fiscal council to help insulate the macro stance of fiscal policy from the pressure cooker of day-to-day politics.
· While I would never suggest stifling debate, politicians, press and pundits should show some restraint in going for easy popularity with loose talk of default. Unfortunately, it probably does affect perceptions of political capacity, with harmful consequences for the risk premium we must bear.
Obstfeld, Maurice. (1996). “Models of Currency Crises with Self-Fulfilling Features.” European Economic Review, 40 (April): 1037-1048.