LA ESPIRAL MORTAL
The death spiral
"I said at the beginning of this newsletter that there were two reasons why I was certain Spain would leave the euro, the first of which has to do with the logic of Spain’s balance of payments position and the second with the internal dynamics that drive the process of financial crisis why I was certain that Spain would leave the euro. To address the second, I think Spain will leave the euro because it seems to me that the country has already started on the self-reinforcing downward spiral that leads to a crisis, and there is no one big enough to reverse the spiral.
How does this process work? It turns out that it is pretty straightforward, and occurs during every one of the sovereign financial crises we have seen in modern history. When a sufficient level of doubt arises about sovereign credibility, all the major economic stakeholders in that country begin to change their behavior in ways that exacerbate the problem of credibility.
Of course as credibility is eroded, this further exacerbates the behavior of these stakeholders. In that case bankruptcy comes, as Hemingway is reported to have said, at first slowly, and then all of a sudden, as the country moves slowly at first and then rapidly towards a breakdown in its debt capacity.
What is key to understanding the process is to see that stakeholders will behave for perfectly rational reasons in ways that politicians and moralists will decry as wholly irrational. Rather however than respond to appeals that they stop behaving irrationally, stakeholders will continue making conditions worse by their behavior as they respond the distorted incentives created by the erosion of sovereign credibility. To do otherwise would almost surely expose them to disaster.
To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:
- Private creditors. As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities. This has a double impact on making conditions worse. First, higher interest rates mean that debt rises more quickly than it otherwise would. Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
- Official lenders. As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority. This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
- Depositors. As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system. As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
- Workers. Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
- Small and medium businesses. One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector. Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation. They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
- Political leaders. As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.
It is important to recognize the almost wholly mechanical nature of credit deterioration once a country is caught in this kind of spiral. Deteriorating creditworthiness forces stakeholders to adjust. Their adjustment causes debt to rise and/or growth to slow, thus eroding creditworthiness further.
The combination of these and other actions by stakeholders, in other words, can’t help but reduce GDP growth, increase debt, and increase the fragility of the balance sheet, all of which of course undermines credibility further, so reinforcing the suboptimal behavior of stakeholders. All of the exhortations by politicians, the church, public intellectuals, bankers, etc. – and there will be many – that stakeholders put personal self-interest aside and act in the best interests of the nation will be useless. Slowing this behavior is not enough. It must be reversed.
But how can it be reversed? No one is big enough credibly to guarantee the creditworthiness of all the afflicted countries, and without a credible guarantee the downward spiral will occur, more or less quickly, until it is clearly unstoppable."
