Part 3: Disappearance of Currency Risk & the Animal Spirits
One Unified Rock Solid Currency Across Heterogeneous Economies
In addition to the factors explained in Part 1 and 2 of this note, one should note the role that the disappearance of currency risk played on the movements of assets within the Eurozone. To simplify, the creation of a unique currency made it possible for assets and liabilities to be matched across borders like never before. German investors could own Italian assets and Spanish investors could own French assets without risk of currency loss. With the flick of a switch, currency risk disappeared. As a consequence, investors who wanted to hold Euros and who have the choice to hold either German Euro debt or Spanish Euro debt for example naturally went for the safer and more prosperous economy. In such a case, what should normally happen is that yields on Spanish debt should rise, but they didn’t, and the reason to that is that the northern European nations were willing to lend to the periphery at relatively low interest rates, as the surpluses generated by Germany were recycled into real estate booms in Spain and elsewhere. The growing imbalances were as much the fault of the creditors – northern European financial institutions and their regulators – as of the debtors.
The Animal Spirits
While the reckless lending from the northern countries to the GIPSI countries was partially due to the disappearance of currency risk, one theory dear to Belgian economist Paul De Grauwe attributes the excessive leverage to self fulfilling waves of optimism and pessimism on the national level. In short, when they joined the Eurozone, GIPSI countries found themselves part of a wider union of countries which was much less likely to fail than its individual members. A wave of optimism followed, which led to a boom in their economy and consequently to a rise in their national wages and prices. Their private sector went on to borrow excessively, and the northern European financial institutions did everything to make this borrowing easier and cheaper. When the wave of optimism changed directions, the southern real estate bubbles went bust, the southern sovereign had to step in to rescue their private sector, and now they are paying the price for it.
Part 4: A Monetary Union and Fiscal Autonomy
When a government that controls both its fiscal and monetary tools runs into trouble and is in need of money, it can typically raise taxes (and potentially run into more trouble by slowing down the economy), or more easily, issue debt and force its central bank to purchase it (which is to say that the government borrows money from its central bank which has an infinite supply of money since it controls the printing press.)
The adherents to the Euro project have all given up the ability to intervene in their economy using monetary policy, since the money supply for the Eurozone is now controlled by the European Central Bank (ECB). During the Drachma era, if Greece for example ran into trouble, it could print the Drachmas it owns to its creditors and give it back to them. Within the Euro zone, it cannot do that anymore. It can still issue as much debt as it wants but it cannot force the ECB to purchase it (it cannot force the ECB to lend money to it).
This has the following consequence: the rate at which countries in the Euro zone borrow money is solely determined by the markets. If the markets think that a country is not credit worthy, they might just cease lending money to it. This is potentially very dangerous and can lead to unsustainable interest rates on the sovereign debt of a country like what I saw on my Bloomberg app mid 2011.
As we have seen, the causes of the Euro crisis are not as simple as the Greeks for being lazy or the Germans being ruthless. It is a combination of circumstances in a system that was never tried before and that some people believe is doomed to fail. I am personally neither pessimistic nor optimistic for the future. I am sceptical. The Eurozone is first and foremost a political project, which might fail because of its economic inconsistency, or which might hold if the political will to remain within a union prevails.