In early November, a European academic, speaking at my central bank seminar, assured a very skeptical group of Peking University undergraduates that no country in Europe would need to leave the euro or restructure its debt (except Greece, which had already restructured). The main problem facing the crisis countries, he said, was a short-term financing gap, and this had become urgent only because of a wave of irrational fear in the financial markets (encouraged, he hinted darkly, by interested foreigners). As this fear subsides, he argued, Europe, with the right set of domestic reforms, could work its way successfully out of the crisis.
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My students were right to be skeptical. Peripheral Europe faces more than a financing gap, and irrational fear is not the main problem. Unfortunately, too many policymakers make the same mistake as the European academic, which only shows how little they understand the balance sheet dynamics that lead to crisis. The recent request by newly elected Spanish Prime Minister Mariano Rajoy -- that financial markets give him a little time, "more than half an hour," to resolve the crisis -- indicates just how confused they are.
This is also the same mistake made a week later by the Hungarian Ministry for National Economy when Moody's downgraded that government's debt to junk status. "Obviously, the forint's weakening is not justified by either the performance of the Hungarian economy, or the shape of the budget," the ministry said. "Therefore, it can be driven only by a speculative attack against Hungary."
Like Rajoy, the Hungarian ministry has missed the point. Hungary's economy will certainly weaken, and the government's budget will deteriorate -- but not because of speculators. What is in fact happening is that many actors, from bondholders to labor unions to entrepreneurs to politicians, will protect themselves from the crisis by responding in ways that unfortunately worsen the crisis, and this worsening of the crisis will put all the more pressure on them to respond further.
There is nothing mysterious about the process. It is widely understood in economic theory that financial-distress costs for overly indebted businesses are actually incurred not at bankruptcy but long before, when weakening credit forces stakeholders to behave in ways that undermine growth and reinforce credit deterioration. This explains why crises tend to move slowly at first and then suddenly spin out of control.
The same thing happens to overly indebted sovereign borrowers. When do they have too much debt? The short answer: They have too much debt when the market believes they have too much. This may seem a trite and even meaningless answer, and the European academic who spoke to my class certainly thought so; but, in fact, understanding this is key to understanding the process of financial collapse.
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