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The Difference Between Illiquidity and insolvency


Paul Krugman on Ireland and the "rescue":

HAMPing Europe's Periphery: The markets don’t seem impressed by the Irish bailout — nor should they be. As I read it, European policy makers are still — still! — viewing the crisis as a confidence problem.... The Irish bailout is not, after all, what one normally thinks of as a bailout.... It’s simply an agreement to lend Ireland funds at more or less safe market rates. Now, this represents a considerable gift relative to the situation Ireland would be in without such funding: Ireland must, as you can see, pay very high rates to borrow on the private market. But if we think about why this is true, we can also see why the bailout isn’t likely to succeed.

The basic situation is that given the cost of rescuing Ireland’s banks, and the damage harsh austerity is inflicting on Ireland’s economy, investors are understandably skeptical that the Irish government will actually be able to meet its commitments. That’s why rates are high — to compensate for a possible default. Now, this process is self-reinforcing: higher rates make it even harder to meet Ireland’s commitments, which leads to still higher rates, and so on. The European bailout basically short-circuits this vicious circle. But the bailout will only work if the vicious circle is at the heart of the story — as opposed to being a symptom of the fundamental unsustainability of the austerity-and-full-repayment strategy. That is, it will work only if Ireland is the fundamentally sound victim of a self-fulfilling panic. And that’s a hard claim to make.

What would Ireland (and Greece, and Portugal, and …) need if the problem is not essentially one of confidence and liquidity? Actual debt relief. Yet that is not on the table. As I suggested in the title of this post, this is somewhat like the failure of the HAMP program, whose whole approach was based on the idea that homeowners essentially had a liquidity problem, so that rescheduling their payments would solve everything.

As it is, I don’t see how this is supposed to work. Ireland, like Greece, is now insulated from the need to go to the market. But it still faces an enormous debt load, made worse by deflation and stagnation. The situation has not been resolved.