Ed Harrison of Credit Writedowns has been one of the clearest writers about the credit crisis in general, and in Europe in particular. His latest at NC:
Here’s the thing: distinguishing between insolvency and illiquidity is a tricky subject because liquidity crises are the market’s way of shaking out the insolvent. Liquidity crises are always solvency crises. The question is about determining which debtor will not be able to repay future principle and interest in a world of incomplete information. If the questionable debtors are large enough, this leads to panic and a wider liquidity crisis that stresses the balance sheets of everyone, including the insolvent debtors. Indeed, the insolvent almost always are shaken out and bankrupted by this process (or are bailed out by government). The problem is that the shake out process kills a lot of other debtors too. If the crisis is large enough, a Depression results.
So, we are now faced with a question: Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.