Predicting the demise, or at least the marginalization of the euro is a popular pastime for some writers (Ambrose Evans-Pritchard of the Telegraph, one of our favorite deflationistas, engages in occasional euro-bashing). Similarly, quite a few investors I know think the euro has no hope of serving as a reserve currency. particularly because some eurozone members could defect as the crisis progresses, calling the future of the entire enterprise in question.
Willem Buiter examines that idea and finds it sorely wanting. Buiter is not obviously disposed to take that point of view, either. While Buiter takes pride in his multiple passports and citoyen du monde pedigree, he has an English sensibility (he adores the Church of England and the Economist, and writes in a decidedly OxBridge style). And most of the noisy Euroskeptics are British (thus more properly Eurosceptics).
But Buiter was also brought in at the 11th hour to advise Iceland as it was going into meltdown mode, so he has a keen appreciation of what can happen to little countries with little currencies that get themselves in a heap of financial trouble. As he sets forth, he thinks it is far wiser to remain in the euro fold than exit it.
A recent (January 13, 2009) column in the Financial Times by John Authers provides a good example of a logical slip on the banana peel of an alleged link between the external value of the euro, the likelihood of the eurozone breaking up and sovereign default by a eurozone national government….
The relevant passages from Authers’ The Short View follow in full:
Greece has always been treated as a peripheral eurozone member, not only in geography. Even before last year’s civil unrest, its bonds traded at a significantly higher yield than those of Germany – showing a higher perceived default risk.
The market is nervous about other nations on the eurozone’s periphery, notably Ireland and Spain, which grew overextended during the credit bubble.
A eurozone country defaulting and leaving the euro is close to an unthinkable event. But Friday’s news from Standard & Poor’s that Greece and Ireland were on review for a possible downgrade, followed yesterday by Spain, left many thinking the unthinkable.
The spread of Greek bonds over German bunds is 2.32 percentage points, almost 10 times its level of two years ago. Spanish spreads yesterday rose above 90 for the first time. An Intrade prediction market future puts the odds on a current eurozone member leaving the euro by the end of next year at about 30 per cent.
The euro dropped more than 1 per cent against the dollar within minutes of the Spanish news, and is down 9.8 per cent in the last few weeks.
Three issues are being linked in this passage. The emergence of high levels of sovereign default risk premium differentials between different eurozone member states, the external value of the euro and the likelihood of the eurozone breaking up. There is no self-evident link between these three issues. The first is neither necessary nor sufficient for the second or the third. More than that, the threat or reality of sovereign default by a eurozone member state is much more likely to reduce that country’s incentive to leave the eurozone than to increase it….
Would a eurozone national government faced either with the looming threat of default or with the reality of a default be incentivised to leave the eurozone? Consider the example of a hypothetical country called Hellas. It could not redenominate its existing stock of euro-denominated obligations in its new currency, let’s call it the New Drachma. That itself would constitute a further act of default. If the New Drachma depreciated sharply against the euro, in both nominal and real terms, following the exit of Hellas from the eurozone, the real value of the government debt-to-GDP ratio would rise. In addition, any new funding through the issuance of New Drachma-denominated sovereign bonds would be subject to an exchange rate risk premium, and these bonds would have to be sold in markets that are less deep and liquid that the market for euro-denominated Hellas debt used to be. So the sovereign eurozone quitter and all who sail in her would be clobbered as regards borrowing costs both on the outstanding stock and on the new flows.
A sharp depreciation of the nominal exchange rate of the New Drachma vis-a-vis the euro would for a short period improve the competitive position of the nation because, with domestic costs and prices sticky in nominal New Drachma terms, a nominal depreciation is also a real depreciation. Nominal rigidities are, however, less important for eurozone economies than for the UK, and much less important than in the US. Real rigidities are what characterises mythical Hellas, as it does real-world Greece, Italy, Spain, Portugal and Ireland. The real benefits from a nominal exchange rate depreciation would be eroded after a year – within two years at most – before you could say cyclical recovery. The New Drachma would be a little currency in a big global financial market system – not an instrument to be used to gain competitive advantage or to respond efficiently to asymmetric shocks, but a source of extraneous noise, excess volatility and persistent misalignments, rather like sterling.
A eurozone member state faced with the prospect of sovereign default, or just having suffered the indignity of sovereign default, would be immensely relieved to be a member of the eurozone. The last thing it would want to do is give up the financial shelter provided by membership in the eurozone to try and emulate Iceland, New Zealand or the UK.
Was the depreciation of the euro that more or less coincided with the sovereign credit warnings and the Greek downgrade (although it started earlier) due to increased concern about the fiscal sustainability of some eurozone member states? Who knows? And what is more: who cares? The eurozone member states no doubt welcome the weakening of the euro, which had become the world’s second most overvalued currency, just as UK Ltd welcomed the decline in sterling, which reached more than 25 percent from its previous peak until the recent weakening of the euro. Depending on the fiscal measures taken by the sovereigns of the fiscally challenged nations, and depending on the response, if any, of the ECB to the threat or reality of sovereign default, any response of the euro can be rationalised.
I view the widening of the sovereign risk spreads inside the eurozone as a welcome development. With the revised Stability and Growth Pact effectively emasculated as a fiscal discipline device, it is essential for national fiscal discipline in the euro area, that the market believes (1) that national sovereign debt is indeed just national, not joint and several among all eurozone member states, and (2) that the ECB will not bail out ex-ante or ex-post a eurozone member state that gets itself into fiscal problems. The very low sovereign risk premium differentials in the early years of the eurozone were worrying to me, because it seemed to indicate that the markets believed that a fiscally incontinent government would be bailed out by the other eurozone national governments or by the ECB. The new larger and healthier sovereign risk premium differentials indicate that the markets may be able to provide more fiscal discipline than suggested by the early years of the common currency. That is good news indeed.
So we may well see sovereign defaults by EU national governments, both inside and outside the eurozone. But it is more likely in my view that Scotland will leave the sterling monetary union (and the United Kingdom) and adopt the euro as its currency than that an existing eurozone member will leave the eurozone. We shall see.
Note the post is a good bit longer, and for those with an interest in this topic, the omitted sections are also instructive.