Chris Van Es

The Perverse Politics of Financial Crisis

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. Unfortunately, those incentives also often bring about crises in the first place.

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.

Whether a borrower like Italy ends up in the lap of good expectations or tumbles into a nightmare scenario often depends upon some “coordinating news.” If everyone expects that a credit-rating downgrade will make Italian debt unsustainable, Italy will indeed default after a downgrade, regardless of the downgrade’s real economic effects. This is the curse of what we economists call multiple equilibria: once I expect others to run for the exit, it is optimal for me to run as well; but if everybody stays put, I have no interest in running.

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