In lectures today we discussed the differences between solvency and liquidity and the interactions between them. Right on time it seems--the story is playing out in Italy today. Read Prof. Nouriel Roubini's op-ed in the FT on Italy here. From the article:
Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.
So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.
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