How Europe can restore financial stability

„Three realities must be recognized if there is to be a chance of success.

First, systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman Brothers go bankrupt. The shattering consequences that had on confidence are still being felt. The European Central Bank is right that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed that because time had passed since the Bear Stearns bailout the market had learned and so was prepared. In fact, the main lessons learned had to do with how to best find the exits, and uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates the official sector — let alone the private sector — is charging for credit would involve burdens on Greece, Ireland and Portugal comparable to the reparations’ burdens that John Maynard Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies but also on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates become insolvent at higher interest rates, putting further pressure on rates, exacerbating solvency worries in a vicious cycle. This has happened in Greece, Portugal and Ireland; it is in danger of happening in Italy and Spain.”