In trying to understand the pattern and timing of government interventions during a financial crisis, we should probably conclude that, to paraphrase the French philosopher Blaise Pascal, politics have incentives that economics cannot understand.
From an economic point of view, the problem is simple. When a sovereign borrower’s solvency has deteriorated sufficiently, its survival becomes dependent on market expectations. If everybody expects Italy to be solvent, they will lend to Italy at a low interest rate. Italy will be able to meet its current obligations, and most likely its future obligations as well. But if many people start to doubt Italy’s solvency and require a large premium to lend, the country’s fiscal deficit will worsen, and it will most likely default.
Whether a borrower like Italy ends up in the lap of good expectations or tumbles into a nightmare scenario often depends upon some “coordinating news.” If everyone expects that a credit-rating downgrade will make Italian debt unsustainable, Italy will indeed default after a downgrade, regardless of the downgrade’s real economic effects. This is the curse of what we economists call multiple equilibria: once I expect others to run for the exit, it is optimal for me to run as well; but if everybody stays put, I have no interest in running.
Given this economic dynamic, there seem to be two obvious policy prescriptions. First, it is too dangerous for any country to come even remotely close to the point where insolvency can be triggered by a sunspot. While nobody knows exactly what this danger level is, it is clear where the alarm starts to arise. Given the enormous cost of a default, any government should stay far away from the danger zone.
The second prescription assumes that if, for any reason, a country does end up in the danger zone, only two responses make economic sense. Either officials recognize immediately the inevitability of default and waste no resources trying to prevent it, or they believe that a default can be avoided and deploy all the resources at their disposal as fast as possible. As in many wars, a staged escalation in a financial crisis often leads to the worst possible outcome: a defeat with large losses.
That, unfortunately, is story of the American authorities’ intervention during the 2008 financial crisis. After the collapse of Bear Stearns, it was clear that more problems were coming, yet the United States government did nothing. In July 2008, when Fannie Mae and Freddie Mac (the government-backed housing-loan agencies) were found to be insolvent, then Treasury Secretary Hank Paulson promised a “bazooka,” but delivered what turned out to be a slingshot. It was only after Lehman Brothers collapsed that Paulson went to Congress seeking $700 billion to stabilize the financial system. Even that turned out to be insufficient.
The same travesty appears to be playing out in Europe. If European officials thought Greece needed to be saved, an immediate European intervention in favor of Greece would have minimized the resources required. If they thought Greece needed to go bankrupt, an immediate decision to that effect would have minimized the cost as well. Now we are already at the second rung of intervention, and there seems to be no end in sight. In the meantime, Italy is sinking.
One could argue that politicians behave this way because they do not understand the economic nature of crises. I disagree. I think that what leads them to behave this way is not lack of knowledge, but perverse incentives.
First of all, even for someone with the best incentives, it is difficult to choose a smaller cost that must be paid now over a larger cost that might fall due in the future. For an elected politician who is unlikely to be in office (or even alive) when the bigger costs materialize, the choice is clear. That is why countries build up debt levels that put them in the danger zone.
Second, there is no political reward for fighting a preventive war, while there is great political capital to be earned by acting after problems have exploded. Had Franklin Roosevelt succeeded in preventing the Pearl Harbor attack with a preemptive strike against Japan, we would still be discussing whether war with Japan was inevitable. Roosevelt waited to act until after the catastrophe, and he has been revered as a savior. To act, politicians need consensus, which often does not emerge until the costs of inaction have become highly visible. By that point, it is often too late to avoid a much worse outcome.
These incentives are present in all democracies. They cannot be eliminated, but they can be tempered. The European Stability and Growth Pact was an effort to accomplish exactly that – by creating incentives for eurozone countries to steer clear of the danger zone for debt. Unfortunately, the pact failed miserably. But if the euro is to survive – and if other countries are to avoid sovereign-debt crises of their own – we still need politician-proof rules.
From an economic point of view, the problem is simple. When a sovereign borrower’s solvency has deteriorated sufficiently, its survival becomes dependent on market expectations. If everybody expects Italy to be solvent, they will lend to Italy at a low interest rate. Italy will be able to meet its current obligations, and most likely its future obligations as well. But if many people start to doubt Italy’s solvency and require a large premium to lend, the country’s fiscal deficit will worsen, and it will most likely default.
Whether a borrower like Italy ends up in the lap of good expectations or tumbles into a nightmare scenario often depends upon some “coordinating news.” If everyone expects that a credit-rating downgrade will make Italian debt unsustainable, Italy will indeed default after a downgrade, regardless of the downgrade’s real economic effects. This is the curse of what we economists call multiple equilibria: once I expect others to run for the exit, it is optimal for me to run as well; but if everybody stays put, I have no interest in running.
Given this economic dynamic, there seem to be two obvious policy prescriptions. First, it is too dangerous for any country to come even remotely close to the point where insolvency can be triggered by a sunspot. While nobody knows exactly what this danger level is, it is clear where the alarm starts to arise. Given the enormous cost of a default, any government should stay far away from the danger zone.
The second prescription assumes that if, for any reason, a country does end up in the danger zone, only two responses make economic sense. Either officials recognize immediately the inevitability of default and waste no resources trying to prevent it, or they believe that a default can be avoided and deploy all the resources at their disposal as fast as possible. As in many wars, a staged escalation in a financial crisis often leads to the worst possible outcome: a defeat with large losses.
That, unfortunately, is story of the American authorities’ intervention during the 2008 financial crisis. After the collapse of Bear Stearns, it was clear that more problems were coming, yet the United States government did nothing. In July 2008, when Fannie Mae and Freddie Mac (the government-backed housing-loan agencies) were found to be insolvent, then Treasury Secretary Hank Paulson promised a “bazooka,” but delivered what turned out to be a slingshot. It was only after Lehman Brothers collapsed that Paulson went to Congress seeking $700 billion to stabilize the financial system. Even that turned out to be insufficient.
The same travesty appears to be playing out in Europe. If European officials thought Greece needed to be saved, an immediate European intervention in favor of Greece would have minimized the resources required. If they thought Greece needed to go bankrupt, an immediate decision to that effect would have minimized the cost as well. Now we are already at the second rung of intervention, and there seems to be no end in sight. In the meantime, Italy is sinking.
One could argue that politicians behave this way because they do not understand the economic nature of crises. I disagree. I think that what leads them to behave this way is not lack of knowledge, but perverse incentives.
First of all, even for someone with the best incentives, it is difficult to choose a smaller cost that must be paid now over a larger cost that might fall due in the future. For an elected politician who is unlikely to be in office (or even alive) when the bigger costs materialize, the choice is clear. That is why countries build up debt levels that put them in the danger zone.
Second, there is no political reward for fighting a preventive war, while there is great political capital to be earned by acting after problems have exploded. Had Franklin Roosevelt succeeded in preventing the Pearl Harbor attack with a preemptive strike against Japan, we would still be discussing whether war with Japan was inevitable. Roosevelt waited to act until after the catastrophe, and he has been revered as a savior. To act, politicians need consensus, which often does not emerge until the costs of inaction have become highly visible. By that point, it is often too late to avoid a much worse outcome.
These incentives are present in all democracies. They cannot be eliminated, but they can be tempered. The European Stability and Growth Pact was an effort to accomplish exactly that – by creating incentives for eurozone countries to steer clear of the danger zone for debt. Unfortunately, the pact failed miserably. But if the euro is to survive – and if other countries are to avoid sovereign-debt crises of their own – we still need politician-proof rules.
Luigi Zingales is Professor of Entrepreneurship and Finance at University of Chicago Graduate School of Business and co-author, with Raghuram G. Rajan, of Saving Capitalism from the Capitalists.
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