In times of trouble, sovereigns, like financial institutions can be either illiquid, or insolvent, or both. In many cases, the distinction is blurred. When uncertainty is high, sovereigns face liquidity shortages, and they can only issue new debt at constantly higher interest rates. This, in turn, creates doubts about their ultimate solvency, triggering a negative spiral. This process is clearly at work in peripheral Europe, especially Spain and Italy, since the beginning of August. 2  BIS central bankers’ speeches  In short, sovereign solvency is partly endogenous. Good fundamentals are an absolute necessity, but not always a sufficient condition. Liquidity spirals, when allowed to develop, can lock a country, just like a financial institution, into a bad equilibrium. What is therefore the appropriate policy reaction? We had a continuing debate on that question in 2009–2010 when dealing with financial institutions. We are faced with the same question now regarding sovereign risk. The standard answer is twofold. First, get the fundamentals right. For European countries, it means reverting to a sustainable fiscal position which, in most cases, necessitates a significant primary surplus. Necessary efforts are greater now since doubts have been created about sovereigns’ ability to meet their obligations. And second, when solvency is achieved, there is a need for a liquidity backstop to ensure that bad equilibria will not be allowed to develop. Where that backstop is coming from is a key question in the current debate.
The unrest increased when it was revealed at the beginning of August that several financial institutions had made significant losses in connection with the US sub-prime market. The background to this was that the number of households experiencing difficulties in paying their mortgages had gradually increased. It was also difficult to assess to what extent the different market agents were exposed to the assets concerned – in which balance sheets the credit risks had ended up. This was the starting point for a more general reassessment of risk in the financial markets. To make a long story short, one can say that the general uncertainty led to an increasing demand for safe assets such as treasuries. Government bond rates have fallen, while rates on some other investments have been pushed up. This is probably because risk premiums have increased, after being very low for a long period of time. For instance, interest rates on loans and deposits between banks, interbank rates, have risen in many countries. For instance, the European Central Bank (ECB) and the Federal Reserve have seen a need to supply extra liquidity to slow down the rise in interbank rates. In the United Kingdom, the Bank of England has chosen to use its position as lender of last resort and to grant emergency liquidity assistance to a mortgage institution, Northern Rock. Emergency liquidity assistance is only given if the institution in question is assessed to be solvent but lacking sufficient liquid funds.