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The Perverse Politics of Financial Crisis

CHICAGO – In trying to understand the pattern and timing of government interventions during a financial crisis, we should probably conclude that, to paraphrase the French philosopher Blaise Pascal, politics have incentives that economics cannot understand.

From an economic point of view, the problem is simple. When a sovereign borrower’s solvency has deteriorated sufficiently, its survival becomes dependent on market expectations. If everybody expects Italy to be solvent, they will lend to Italy at a low interest rate. Italy will be able to meet its current obligations, and most likely its future obligations as well. But if many people start to doubt Italy’s solvency and require a large premium to lend, the country’s fiscal deficit will worsen, and it will most likely default.