Self-fulfilling Crisis
Source: http://krugman.blogs.nytimes.com/2011/08/07/a-self-fulfilling-euro-crisis-wonkish/?_r=0
About 5 years ago, European Central Bank (ECB) resumed government bond-buying schemes, primarily to ease EU-wide economic crises that swept some of the EU countries. Paul Krugman, in his New York Times blog article, discusses this issue and analyses the big question of whether ECB’s bond purchase can be the fundamental solution to both Spain’s and Italy’s economic failure. While doing so, he brings up an interesting term of self-fulfilling crises.
Often times in class, we witnessed several occasions where buyers’ expectation of the market heavily influenced how the actual market would turn out. In the case of Eurozone crisis, Krugman points out people’s fear and anxiety of possible governmental default as a primary factor that can worsen the situation. Of course, if the debt is way too big and the country needs a large fiscal adjustment, mere pessimism can’t worsen the situation too much. However, if the problem is somehow solvable with fairly little fiscal adjustment (as in the case of Italy), people’s pessimistic outlook can have devastating result. If people begin to grow wary of default, government does need to raise the interest rate to a point that, ironically, would make default as the most plausible option left, whereas if the interest rates stayed low, the problem can be solved with only a little fiscal adjustment.
The definition of self-fulfilling crisis is similar to information cascade in a sense that group behaviour can affect the entire market. Thinking from this notion, it is also a crucial role for government to control the group behaviour effectively so that it doesn’t drive national economy into unnecessary failure. One famous example is Franklin Delano Roosevelt, who delivered his Fireside Chat to ease American people’s anxiety over economic failures and eventually persuaded them to not withdraw the money from the bank.