DG - "What size is the fire exit?" by Daniel Gros

What size is the fire exit?
Daniel Gros
7 December 2010

"...After all, the claim that the risk of loss will arise only for debt issued after the new crisis-resolution mechanism starts in 2014 implies that all debt issued until then is safe, and that insolvency can occur only in some distant future, rather than now, as in Greece and Ireland. In effect, EU officials are saying to investors, “Whom do you believe – us or your own eyes?” Moreover, for too many investors, Portugal, with its poor growth prospects and insufficient domestic savings to fund the public-sector deficit, looks like Greece. And Spain clearly has to grapple with its own Irish problem, namely a huge housing over-hang – and probably large losses in the banking sector – following the collapse of an outsized real-estate bubble. The problems of Portugal and Spain might be less severe than those of Greece and Ireland, but this apparently is not enough to induce investors to buy their government debt. A risk these countries share is thus the acute danger of large-scale runs on their banking systems. So far, investors trying to exit first have been made whole. Holders of Greek debt maturing now are repaid courtesy of the €110 billion bailout programme, and holders of Irish bank bonds have been given a guarantee by the Irish government, whose promises have in turn been underwritten by the EFSF. The EFSF will also provide funds to ensure that Irish banks’ depositors can get their money back today.
The problem with this approach is that it creates the wrong incentives. Investors have now learned that the first to sell will avoid losses. The situation resembles that of a crowded cinema with only one exit. Everyone knows that in case of fire, only the first to leave will be safe. So, if the exit is small, even the faintest whiff of smoke can trigger a stampede. But if the exit looks comfortably large, the public will be much more likely to remain calm, even if parts of the room are already filling with smoke..."

"To return to the cinema analogy: investors know that the exit is not large enough to allow them all to squeeze through at the same time. So each one wants to be among the first to get out. The official line so far has been “no default”, meaning no sovereign default or that of any bank can be considered. If this line is to be maintained, the exit door must immediately be made much wider, and huge fire extinguishers must be brandished. The International Monetary Fund and the European Central Bank must show investors that they have enough funding to finance the simultaneous exit of all short-term investors.
It could work. A show of overwhelming force might restore calm to the markets. But it is a risky proposition: if investors exit nonetheless, the required funds might be so large that creditor countries’ taxpayers’ revolt..."

[Mrt: It does resemble of something familiar, doesn´t it?]

Source: What size is the fire exit?