European Sovereigns Are The New Banks

Everyone understands the classic bank run scenario. If everyone loses confidence in the future of a bank, everyone will withdraw their money and the bank will fail. Consequently, the mere suspicion that a bank is running into trouble can create a self-fulfilling prophesy. A firm that needs to roll over a large quantity of debt on an annual basis is in the same situation. For that matter, so can a country.

That said, we normally only think of this kind of panic as afflicting developing countries because rich countries borrow in their own currency. If the United States government faces a severe liquidity crunch of some kind, there’s always a Federal Reserve System ready to stand behind it. But one of the things we’ve seen during the current crisis is that the European Central Bank (presumably with the arm of Angela Merkel standing behind it) is unwilling to play this “lender of last resort” role. That’s a problem for Italy right now. But in many ways it’s a much more profound issue. Financial markets are done treating Italy — and today it looks like maybe even France — like a risk-free sovereign. But if the European Central Bank is genuinely committed to this no lender of last resort principle, that means that Germany, Finland, the Netherlands, and everyplace else are structurally more akin to Belize or Botswana than to the United States or United Kingdom. They’re all vulnerable to runs in a way countries backstopped by a lender of last resort aren’t.