This time is (not) different

Euro coins

Euro coins

Here we are at it again.

Heads of state of EU countries meet. Drafts of big, ambitious programs of reform are circulated and voted upon. Significant proclamations are given to the media. Markets are tamed for a few days. Markets turn wild once again.

This sequence of events has occurred several times over the last few months. Unfortunately, all of it is to no avail, if the ultimate goal is to permanently placate the turbulent behavior of global financial markets.

As I argued in my previous blog post, this is unsurprising and will continue to occur. The reforms being discussed, the new infrastructures being designed and built, the fiscal plans being approved will “at best” affect (and not obviously positively) the interested economies in years to come, not in the next few days or weeks. The markets, severely dislocated as they are, will continue to spin unabated.

Breaking this spiral of frustration requires a clear understanding of the following notion: Markets are not moving away from European sovereign debt because of poor fundamentals, or solvency issues (read: EU countries’ inability to pay off their debts); market participants are selling EU bonds because other market participants are, in a vicious spiral that is well-known in Financial Economics as a “run.” While typically banks are most sensitive to runs, they can occur in currency, stock, and bond markets as well.

A run usually starts when, in an already fragile environment (as in the EU over the last 18 months, following strains in Ireland, Greece, and Portugal) some investors begin to move away from risky securities. Their sales may or may not be “reasonable.” Unfortunately, it does not matter. Once the selling begins and builds up, for “reasonable” investors there are only two options: either ignore the selling or try to sell faster than the sellers, before prices drop too much. The latter is almost always more rational than the former. More selling induces more people to enter the fray and sell more. Rating agencies, alarmed by declining prices (not by fundamental information…I will leave this discussion to a future blog post), fuel the panic selling by downgrading the affected assets. More selling ensues, and the spiral continues on and on.

These spirals can very rarely be reversed by attempting to convince investors of the fundamental “goodness” of the assets being sold. There is simply no time for that: First I need to sell, then I will read the news about the EU meetings. These spirals, we know from a very well-developed literature, can be convincingly interrupted only by effectively making investors indifferent between running and not running.

Federal Deposit Insurance does just that in the U.S.: any deposit of $250,000 or less at a U.S. bank will be fully reimbursed in case of that bank’s default. Thus, insofar as my deposit is FDIC insured and smaller than $250K and I believe in that promise, seeing my neighbors running to the local bank branch to withdraw their money won’t make me get off my couch and run with them. FDIC insurance exists because banks are fragile: They do not keep as much money as depositors have given them, because banks use a large chunk of that money for loans. Thus, if all depositors decided to withdraw their money at the same time, no bank could avoid a default.

Most governments are as fragile as banks. Governments are solvent only insofar as they can pay their debts over time and/or refinance part of their debt exposure. If all debt-holders asked to be repaid at the same time, no large sovereign borrower could satisfy them. Thus, a well-functioning market in which governments can auction new bonds to pay off the hold ones is indispensable to those governments’ solvency. In Europe, such market has virtually vaporized in the presence of a debt run.

So here is the crux of the matter: Investors will continue to run unless they can be credibly convinced that running is futile. Investors are normal, effort-adverse people: Why should they continue to run if there is nothing to gain from running? Credibly committing the European Central Bank to purchase EU sovereign debt if interest rates on it are too high will suffice. The ECB has infinitely deep pockets, since it can print Euros for as long as it has paper and printing machines. Inflation pressures are non-existent and no speculator can outdo the ECB. There are also more draconian alternatives, some of which have been used even in the U.S.: declaring an extended bank holiday (as FDR did when first elected President in 1933) shutting down financial markets until panic selling recedes is only one example.

In light of these arguments, on days when I feel pessimistic about the events in Europe I wonder if any European policymaker is aware that these high-flying EU-level meetings are futile. On most days, and today is one of those, I do believe that EU policymakers are aware of the mechanisms I described above. I went to college at Bocconi University during a time when (now-Prime Minister of Italy) Mario Monti was both in its faculty (teaching banking!) and its Dean. Mario Monti knows what a bank run is. So does Mario Draghi, the ECB President. I believe there cannot be any doubt among these and other EU figures of leadership that ECB intervention as lender of last resort is the only effective measure that will restore order. I suspect the ECB is employing this knowledge as its only effective tool to extract as many fiscal integration concessions as possible from individual EU leaders before declaring the obvious: “I am a lender of last resort, try me.”

This may be a calculated risk, possibly one of the costliest ones I have seen. With this in mind, I will continue to stay seated on my couch and watch my beloved Napoli perform well in the Champions League.

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About ppasquar

Associate Professor of Finance at the Ross School of Business, and long-term Napoli fan.
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