Italy’s 'this time it’s different' moment: With rejoinder by Giavazzi

"The recent article by Francesco Giavazzi is both depressing and déjà vu all over again.

• In early 2010, when the situation started to deteriorate in Greece and some eggheads opinionated that an IMF program was unavoidable – the Greeks replied "we are not Latin America";
• Half a year later, the Irish stated that they were not Greeks;
• Then the Portuguese insisted that they were not Ireland;
• Just a few months ago, the Spaniards claimed that they were not Portuguese.

Now guess what – the Italians remind us that Italy is not Spain.

As Reinhart and Rogoff (2009) have recalled, every country that faces a crisis always denies that it is fodder for IMF-style conditionality. In fact, you know that the point of no return has been reached the minute policymakers – or influential commentators – explain that their country is different.
And, yet, they are right. It is true that Italy’s fundamentals are clearly different from Spain’s fundamentals, which are different from those in Greece, Ireland and Portugal. What these countries have in common is that they have lost market access, at least at 'normal' interest rates.

The underlying economic mechanism is self-fulfilling market expectations, a.k.a. multiple equilibria. Rightly or wrongly, once markets conclude that a country’ situation is hopeless:

• Interest spreads start rising;
• Debt service becomes explosive; and
• The situation eventually becomes hopeless.

Back in 2009, Greece did not have to get into a crisis. Nor did Korea in 1997, nor Mexico in 1986, nor Chile in 1982. In all these cases, the fundamentals were less than rock-solid, but they were not completely disastrous either. In each case, once the crisis occurred, hard-nosed observers, who had failed to predict what was to happen, went on drawing a list of alarming policy failures that fully justified the crisis and the harsh treatment imposed on the now-delinquent country.

What we know full well, at least since Obstfeld (1986) and Krugman (1986), is that a crisis can (but does not have to) occur when a country suffers from a vulnerability. We also know that, once a self-fulfilling crisis occurs, it tends to spread in a contagious way. Research has still to unearth cases when a country that moved into a bad equilibrium was able to recover to a good equilibrium..."

 

at http://www.voxeu.org/article/italy-s-time-it-s-different-moment-rejoinder-giavazzi