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. Continue reading “Self-Fulfilling Crises: Lessons from 1992/93”