How Does the Economy Choose Which Equilibrium to Settle at?: Praying for the Confidence Fairy to Rescue Italy Edition
Martin Feldstein claims that Italy does not need anybody else's help:
Italy can save itself and the euro: The euro currency may soon collapse even though there is no fundamental reason for it to fail. Everything depends on Italy, because financial markets now fear that it may be insolvent. If the Italian government has to continue paying a seven or even eight per cent interest rate to finance its debt, the country’s total debt will grow faster than its annual output and therefore faster than its ability to service that debt. If investors expect that to persist, they will stop lending to Italy. At that point, it will be forced to leave the euro. And if it does, the value of the “new lira” will reduce the price of Italian goods in general and Italian exports in particular. The resulting competitive pressure could then force France to leave the euro as well, bringing the monetary union to an end.
But this need not happen. Italy can save both its own economic sovereignty and the euro if it acts decisively and quickly to convince the financial markets that it will balance its budget and increase its rate of economic growth…. It already has a “primary budget surplus”…. [I]f it cuts spending and raises revenue by a total of just three per cent of its GDP…. If reforms to strengthen incentives and reduce regulatory impediments raise [its economic] growth rate to two per cent, that together with a long-term balanced budget would cause Italy’s public debt to decline from today’s 120 per cent of GDP to about 65 per cent over the next 15 years [if Italy can borrow at the 4% it borrowed at before the crisis began]….
Italy’s situation is totally different from Greece’s. The latter has a budget deficit of nine per cent of GDP and its real GDP is declining at seven per cent [per year]…. The over-valued exchange rate results in a current account deficit of ten per cent of its GDP. Greece would be better off if it abandons the euro, devalues its new currency, and defaults on its debt.
A decision by Athens to leave the euro and default could cause a run on the euro and on Italian debt in particular. That’s why it is so important for Italy to stress that its conditions are totally different….
Italy can do all of this itself. It does not need assistance from Frankfurt, Brussels, or Washington. The proposed policies for help from the European Central Bank, the European Commission, and the International Monetary Fund would ultimately weaken Italy and undermine its economic independence….
Any of these proposed programmes would create new conflicts within Europe as borrower governments are forced to relinquish their ability to set their own national tax and spending policies…. The riots and political upheavals in Greece are a symptom of what would happen more generally if the Brussels bureaucracy and the German Chancellor came to dominate national economic policies.
Fortunately, none of this is necessary if Italy now acts forcefully to create budget and growth conditions that imply sustainable debt outcomes. But impatience and scepticism in financial markets may cause a deeper financial crisis before Italy has time to prove itself.
Yes, if Italy cuts spending by 1% of GDP, improves tax compliance by 2% of GDP, and manages to boost its economic growth rate from 1% per year to 2% per year, then if it can borrow at 4% per year then its debt is sustainable--and if you bet in financial markets that Italy will default, you will lose your money.
But even if Italy cuts spending by 1% of GDP, improves tax compliance by 2% of GDP, and manages to boost its economic growth rate from 1% per year to 2% per year, if it nevertheless finds that it can only borrow at 8% per year then its debt is unsustainable--and if you bet in financial markets that Italy will default, you will lose your money.
There are two equilibria out there if Italy reforms its policies: There is one in which investors lose money if they bet Italy will default even if Italy undertakes minor policy reforms--and if investors believe that we are in this equilibrium we will indeed be in this equilibrium and investors who bet Italy will default will lose their money. There is another equilibrium in which investors lose money if they bet Italy will not default if Italy undertakes minor policy reforms--and if investors believe that we are in that equilibrium we will indeed be in that equilibrium, and investors who bet Italy will not default will lose their money, and all the policy adjustments Italy can undertake by itself will not help.
What can the world do to make financial markets--and Italy, and the eurozone--settle at the first equilibrium?
Martin Feldstein appears to argue that the world should let Italy undertake its economic policy reforms by itself, and otherwise it should stand back and pray for the appearance of the Confidence Fairy.
I don't think that the Confidence Fairy is guaranteed to show up.
I think that if the assembled credit-worthy sovereigns of the globe--the money-printers: the BOJ, the ECB, the FRB, the BoE, and the IMF--show up and say that if you bet on the bad equilibrium we will ruin you, because we will buy up as many Italian government bonds as needed to cut Italy to the good equilibrium, and if they then start buying, then we do not need to pray for the Confidence Fairy because we are in the good equilibrium whether the Confidence Fairy shows up or not.
And by one of the arcana imperii of monetary and financial policy, the best way to guarantee that the Confidence Fairy will show up is not to need to pray for it--and so if the money-printers show up, they probably won't have to buy Italian government bonds because everybody will see that holding Italian government bonds is a way to profit and selling Italian government bonds short is a way to bankruptcy.
The problem, of course, is what if the money-printers show up but Italy does not undertake its structural adjustment...