Sovereign Risk and Macroeconomic Instability Post author By Philip Lane Post date August 12, 2011 Giancarlo Corsetti and Gernot Mueller explain how sovereign risk damages growth prospects in this VOXEU article. Categories In Uncategorized 2 Comments on Sovereign Risk and Macroeconomic Instability ← Daniel Gros: Turn the EFSF into a bank → Smart Economy Jobs in Irish Regions 2 replies on “Sovereign Risk and Macroeconomic Instability” “Economies are most vulnerable when sovereign risk is high and, in addition, the central bank is constrained in its capacity to lower interest rates (by the zero lower bound or by an exchange rate peg).” So we need either an ECB which is prepared to live with higher steady-state inflation and nominal interest rates (hence no ZLB problem) or the removal of the exchange rate peg, i.e. goodbye Eurozone. I’d say the former is out of the question. But the fact that the EZ needs to go doesn’t mean it will go anytime soon. In the current situation the authors are surely right to say that “immediate fiscal consolidation may be the lesser of two evils for many countries” but how long will the people of those countries tolerate that situation? ‘Importantly, the evidence in Figure 1 may still understate the strength of the sovereign-risk channel, as most of the corporations in the underlying sample are large international players with direct access to bond markets. Such companies can free themselves to a greater extent from their national sovereign than smaller firms that rely on local bank financing. …………………………. At times of intense financial market pressure – with high risk premia on government debt – the use of expansionary fiscal stimulus is bound to worsen the fiscal outlook and, hence, jeopardise macroeconomic stability. Any desirable stimulus effects are likely to be offset by the negative impact of the sovereign-risk channel – unless the government is able to commit immediately and credibly to medium-term consolidation measures that eradicate sovereign risk at its roots’’ Victor Mallet has a report in the paper edition of the IT today, ‘Spanish banks continue to block credit despite risk of new recession’. For their own survival, they are letting their clients sink. It’s dog eat dog at this stage. Unlike Spain, we have a (relative to us) huge finance-centred MNC enclave. That sector drives GDP, and is insulated from the tribulations of the Irish sovereign. It will carry on until the credit in the US, or the Corpo Tax landscape, call a halt, but it will never provide more than fraction of the necessary employment. No credit links, few employment links, and damn little spinoffs in terms of niche opportunities. No disrespect to those who work in the FDI sector, but it’s been dreadfully overhyped. It’s the domestic private sector which is decimated. Banks can’t, and won’t be lending into Ireland for the foreseeable. The advice here is to throw public services into the bin along with it. To cut blindly in an environment where private sector deleveraging is gathering pace seems like a psychiatric condition. The very notion of ‘eradicating sovereign risk at its roots’ is in the face of all we know about Keynesian uncertainty. We could, however, succeed in eradicating what’s left of the domestic economy if we are not careful. Comments are closed.