Self-Destructive, Yet Rational Behavior Will Lead to Spanish Exit

To summarize what the self-destructive and automatic behavior of the stakeholders is likely to be, it is worth identifying some of the major stakeholders and to suggest how they typically react to a rise in the sovereign’s default risk:

1. Private creditors.  As Spain’s credibility deteriorates, private creditors will demand higher yields on their loans to Spain even as they change the form of their lending to reduce their own risk, for example by shortening maturities.  This has a double impact on making conditions worse.  First, higher interest rates mean that debt rises more quickly than it otherwise would.  Second, shorter maturities and other changes in the loan structure mean greater balance sheet fragility and a rising probability of default.
2. Official lenders.  As they are forced into providing liquidity facilities, official creditors typically demand and receive seniority.  This of course increases the riskiness for other lenders and creditors by pushing risk downwards, and so worsens balance sheet fragility and increases private sector reluctance to lend.
3. Depositors.  As the probability rises that Spain will leave the euro, and that bank deposits will be frozen and redenominated in the weaker currency before any abandonment of the euro is announced, depositors respond rationally by taking money out of the banking system.  As they do, banks are forced to contract lending, to increase balance sheet liquidity, and to reduce risk, all of which act as a drag on economic growth.
4. Workers.  Rising unemployment and the prospects for an unequal sharing of the burden of adjustment cause unions to become increasingly militant and to engage more often in various forms of industrial action, which, by raising uncertainty and costs for businesses, force them to cut output and employment.
5. Small and medium businesses.  One of the sectors most likely to be penalized in a debt crisis is the small and medium enterprise sector.  Owners of small and medium businesses know that they are vulnerable during a crisis to an expropriation of their wealth through taxes, price and wage controls, and other forms of indirect expropriation.  They try to forestall this by disinvesting, cutting back on expenses, and taking money out of the country.
6. Political leaders.  As time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms.

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Europe’s Depressing Prospects: Two Reasons Why Spain Will Leave the Euro
By Michael Pettis

Pettis’ point above (and in the rest of the piece) is essential to understanding the situation in Europe because it focuses on actual responses and not abstract ideals. Many economists seem to overlook the simple fact that the individual dynamics of each party are a rational response to the troublesome predicament. Any resolution that keeps Spain in the monetary union therefore requires at least one of the parties to act irrationally, effectively placing the priorities of the other groups above their own (and accepting the risks if others don’t follow). It is often suggested that political leaders will ultimately recognize the massive costs of continuing to focus on the short-term and change course. Well, it has been 3 years since the crisis began and we are still waiting...