Expectations can severely impact the economic outlook even if economic fundamentals are stable.

I mentioned that a multiple equilibria can arise depending on how expectations will be shaped: even if economic fundamentals, namely the key indicators including the budget deficit, current account deficit and public debt and monetary and fiscal policies do not change, the economy can move to a bad equilibrium as expectations deteriorate, or vice versa. If expectations are positive, the outlook of the economy can improve even if economic fundamentals did not enhance.

Particularly economies with high public debt as a natural outcome of loose fiscal policy practices encounter the problem of “multiple equilibria.” Just as Italy does today. Even if you declare that loose fiscal policy practices are dismissed forever and introduce a series of measures to ensure fiscal discipline to prove that you are committed to your objective, you may fail to convince financial markets.

Budget deficit, that is, the borrowing requirement, cannot be swept overnight. When countries with high public debt attempt to sell securities for new borrowing, potential buyers will generally demand high interest rates, even if the country has already taken important steps to assure fiscal discipline. There are a couple of reasons for this. First, certain developments raise the perception that fiscal discipline might not be sustained. For instance, the political party expected to win the coming elections might oppose to the program or street protests against austerity policies might escalate. Second, there is a common belief that the economic policy in place will prevent economic growth for a couple of years ahead. Therefore, markets focus on the worst-case scenario in which economic contraction takes place, lowering tax revenues and disturbing the efforts to ensure fiscal discipline. In addition, in the face of an economic contraction, social unrest is expected to grow.

Thus, potential buyers of securities have “valid” reasons for asking high interest. On the other hand, high interest rates have the potential of tearing down the efforts for disciplining the budget. Any rise in interest rates worsens the confidence in the economy, later pushing up interest rates again. The country in question therefore gets stuck in a vicious cycle. If expectations were not negative, the cycle wouldn’t be created in the first place and the public debt would most probably be reduced via the economic policies in effect. And market players would lower the interest they demand, which in turn would improve the budget dynamics and reduce the budget debt further. Then, the borrowing requirement and interest rates would decrease further. Yes, this also is a cycle, but not a vicious one. This time the cycle would bring recovery, gradually eliminating core economic problems.

Unfortunately, if once worsened, it is very hard to reverse the expectations about the state of a certain economy. Especially if the country in question does not have an independent monetary policy, like Italy. If they had a national central bank, the bank could purchase securities and prevent a hike in interest on borrowings provided that its actions are accompanied by a solid agenda for budget discipline and structural reform. For instance, the hike in Spain’s public debt was caused mainly by the bailout operations. If Spain had a national central bank, the bank could step up and stop the process from the start. Turkey initiated a similar operation right after the 2001 crisis, which played a major role in preventing the program from moving the economy into a “bad equilibrium.” This should not be overlooked when trying to understand the current deadlock facing Europe. I will continue.

This commentary was published in Radikal daily on 23.08.2012