The illustrated euro crisis: Multiple equilibria

Oct 7th 2011, 18:37 by G.I. | WASHINGTON

Italian bond yields rise. Credit rating agencies worry that higher yields make Italy’s debt unsustainable. They cut Italy’s bond rating. Italy promises to curtail its deficit (i.e. sell fewer bonds). Italian growth suffers. Investors worry that makes Italy’s debt less sustainable at current interest rates. Demand for Italian bonds falls, their yields rise. You get the picture.

But  in case you don’t, look at this one. Courtesy of the Bank Credit Analyst, it nicely illustrates the dilemma facing euro zone peripheral sovereigns. In normal times (upper part of the chart), demand for Italian bonds is downward sloping. As prices fall (yields rise), demand rises. But at a certain point, higher yields call into question Italy’s solvency, and demand actually falls. In this zone of vulnerability, the demand curve is upward sloping. Only once Italian bond prices fall into distressed territory, presumably at much lower deficits and levels of GDP, does the curve resume its normal shape.

The BCA writes:

 

The possibility of speculative attacks blurs the distinction between liquidity and solvency. As a result, there may not be any single unique “equilibrium” for debt yields. Rather, debt markets may be subject to multiple equilibria … In such an environment, shifts in financing costs can lead to a wide variation in the possible trajectories of debt-to-GDP ratios over time, which serves to exacerbate market anxiety. Faced with such multiple equilibria, it is a central bank’s responsibility to ensure that the “good” (i.e. low yield) equilibrium is reached. The fact that the ECB has yet to grasp this lesson is bewildering.

 

The original post is linked here.

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