The Euro Crisis and Euro Bonds-Becker

After the financial crisis erupted in 2008, continental Europe on the whole appeared to be in better shape than the US. The main reason was that the big EU banks held smaller amounts of questionable mortgage-backed securities than did American (and British) banks. The housing markets in Germany, France, Italy, and most other member countries-Spain and Ireland are two exceptions- had not boomed as much as the American and British markets.

Unfortunately, the apparent more solid position of EU banks has turned out to be an illusion because these banks held large amounts of euro-denominated sovereign debt of Greece, Portugal, Italy, and other economically weak members of the EU. The presumption of EU banks in holdong so much sovereign debt of weak members was that the strong members would not allow defaults on any sovereign debts issued in Euros. This same presumption led the now bankrupt American fund, MF Global Holdings, to bet billions of dollars on the expectation that sovereign debt of all members of the euro-zone would be paid off in full.

This same expectation explains why initially the weaker “Mediterranean” countries were the most eager to join the euro bloc. They anticipated much lower interest costs on their sovereign debt because they expected the strong EU nations to provide a guarantee of their debt. These countries also expected that the Maastricht Treaty and other fiscal rules would prevent their governments from running up large deficits. At first, these expectations were met, as interest rates on the sovereign debt of weaker countries fell to levels not much above that of Germany’s, the strongest member of the EU. The significant fiscal deficits of the weaker EU members did not seem important in a world with booming EU and world economies.

All these expectations crashed with the onset of the Great Recession, and the resulting decline in government revenues, and the retreat by banks and other investors from risky assets. As a result, interest rate spreads between sovereign debt of Germany and France and countries like Greece, Portugal, and Italy have soared, and some direct or indirect default on the sovereign debt of these weak countries seems highly likely- which is why they are being forced to pay higher interest rates on new debt.

What can be done now to prevent a catastrophe in the EU that would plunge Europe into another recession, and hurt badly the world economy as well? I opposed the formation of a common European currency because it did not allow weaker members enough levers to adjust to various idiosyncratic shocks they would inevitably face. This view has turned out to be correct, but a return to separate currencies in the middle of the crisis is likely to be highly disruptive.

At the opposite extreme of a break-up of the euro are proposals for some or all of the sovereign debts of individual member countries to be replaced by euro bonds guaranteed by the EU community as a whole (read mainly Germany and France). One recent idea advanced by Germany’s Council of Economic Experts is to have joint liability for all euro-zone debt above 60% of a country’s GDP, while each country would still have to manage payments on the rest of its debt. Even with high interest rates of 7% or more, weaker countries might be able to manage interest payments on debt equal to 60% of its GDP. Presumably, moreover, these interest rates will fall when the EU is guaranteeing a good portion of the total debt. The EU share of the debt would be paid off over a 25-year time period through tax revenues set aside for this purpose.

In the short run this is likely to reduce significantly the crisis. This is especially so if taxpayers in Germany and elsewhere do not rebel either at the additional taxes they will have to pay to fund the sovereign debts of weak members, or if banks get off lightly despite their risky investments in sovereign debt. In the longer run, this plan for euro bonds backed by joint liability of EU countries would require joint control over issue of debt above the 60% mark since that debt would be the obligation of all euro-zone countries. This would necessarily lead to some type of at least temporary fiscal union regarding sovereign debt issue.

Many have recognized that fiscal union is a necessary part of any long-term solution to maintaining the euro. The euro bond approach set out in the previous paragraph is an indirect way to achieve at least partial fiscal union. It will be helpful in the short run, but I doubt if fiscal union alone will preserve the euro in the long run. Weaker member nations will continue to be stressed by shocks to their economy and to their fiscal balance sheets, with many of these shocks not easy to anticipate in advance. The crisis helps demonstrate that a common currency makes adjustment to individual country shocks far more difficult than when countries can devalue their own currencies. This will continue to be a devastating weakness of the euro unless labor and product markets became much more flexible in the euro-zone, and unless labor mobility across member nations increases greatly.

 

Comments

[TANSTAAFL]

Instructive post by Becker. Note the parallel between the structural flaw in the common European currency and the U.S. dollar, the common currency of 50 states, some of which are fiscally irresponsible and effectively free-ride on their responsible brethren (with lubrication by the Federal Reserve and Congress).

[U. Von Stahler]

SOCIAL-DEMOCRACY FOR ME BUT NOT FOR THEE

The hypocrisy of the Northern Europeans:

Countries of Northern Europe are economically stronger (well “stronger” in quotes because even the “dynamic” economies of Europe grow at a lackluster below-par annual growth rate of around 2% average). That, against the backdrop of a world that is growing at around 5% as a whole. So, essentially, even the “stronger” economies of Europe are simply just declining at a slower rate.

The Southern countries (where European level tax rates make it easier for citizens to place secondary importance on work and head for the beach), are declining even faster, with 0-1% average growth rates in the last decade and low growth rates for at least a generation. With the massive economic awakening of Asia and other developing nations (representing half the world’s population) these slower growth amongst slow growth Southern European countries are simply floating into economic oblivion at a very fast rate, by historical standards.

So the only intermediate solution is for the European North to “help” the European South through wealth transfers from the slower declining North to the more indolence prone South.

Hence here comes the Welfare-State hypocrisy of the Northern countries, who essentially advocate Socialism for me but not for thee. So while those less productive amongst Germans, Dutch, Austrians have a right to be supported by their more productive countrymen, the same support is denied to the less productive citizens of the south.

In a Unified Social-Democratic Europe, obligation to support those who choose indolence becomes universal. It does not matter whether the less productive are Germans, Austrians, Greeks or Italians. Social Democracy obligates productive to support less-productive, less-competent etc. There can be no exceptions and any other stance by countries who collectively call themselves Social-Democracies is ethically inconsistent and hypocritical.

So here indeed comes the hypocrisy of European democracy. The only reason Southern European indolence does not have access to German wealth is that the South does not vote in Germany. But with further unification, citizens of the south will either directly or indirectly GET those voting rights… and claim their Social-Democratic entitlement.

[NEH]

There is more to being a seamless economic zone than just simply creating a unified currency. As the Eurozone has found out. With the loss of multiple currencies controlled individually by member Nations, this has removed a invaluble tool from the National Economic toolbox. By allowing Countries to float their currency value on the Market by either inflating or devaluing it (sounds an awful lot like the Yuan issue) dependent on the underlying economic requirements and required actions.

As for the basic problem, it all comes down to the issues of "quantity" and "velocity" of currency flow. Such that, during the Boom years, there was an incredibly high quantity and velocity of currency flowing through the Zone. Which covered the interest on debt and the debt itself which was incurred. With the collapse of this economic high velocity order the weaker Economic States were left high and dry and unable to service its debt. Hence the problem.

As for the development of Euro Bonds, it hopefully will allow the Eurozone to modify the large quantity, high velocity Currency system to a more slow paced and rational Currency flow that the weak Economic Nations can sustain and hopefully keep a portion of the World's Currency system from spinning out of control again. But, only time will tell...

[Back Taxes]

China will lead us out of this mess. I hope....

[Cheap Moncler Sale]

We have nothing like that in place or even in mind.

[Cheap Air Max]

There is something more to be of value—something I should find within myself—as peace of mind, patience, grace and being kind.

[Air Force One]

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[Christian Louboutin UK]

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[Air Max 2011]

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[Monster Beats Dre]

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[Monster Beats Studio]

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[Cheap Scarf Online]

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[Citizen]

As an addendum to your post, in Rogoff and Reinhart's recent book "This Time is Different", [apologies if my numbers are somewhat off] they found that >50% of sovereign foreign defaults involved debt to GDP rations below 60%.

My general sense is that if - a big IF - Italy were to make some of the needed structural reforms, it could grow out of its debt problems, which are more manageable as Italy is a nation of savers who own a lot of debt. In that sense, Italy's high interest rates are more of a confidence or liquidity problem, and therefore more deserving of a stopgap loan program.

Certainly Greece, and probably Spain and Portugal, have no economic base to support their debt and should be put through and orderly default.

[Jack]

Tans -- A rare opp for agreement! Yes, it's naive to expect all regions of a huge economic system to grow and prosper equally. As you point out here in the US most of our "red" states and even "red" counties have a long history of being net parasites on the public purse. But, "all in" (private sector and all) it's likely less true and perhaps not true at all... id publicly costly "western water projects" likely give us a good return via cheaper ag products. And while gobs of money is coined on NY's Wall Street, it's what they term "flyover country" that provides them with cheap corn flakes.

One good thing in the US, that may be difficult to implement in the EU is the right of labor to move where it pleases. Imagine if former slaves were trapped in their states while the auto and industrial boom took place in MI, IL, OH and others. Or as farming become so automated and productive were labor stuck in Nebraska.

One thing the potentially "revolting" taxpayers of Germany and France will have to learn is that throwing in together is likely to have more benefits overall, than the losses of having to pay one, two or more laggard's bills. Will they have the patience and tolerance for E pluribus unum?

Suppose that in the mid-1800's the US had decided it shared to little from one region to another and we had become two nations? or after that the West splitting off. Or the Louisiana Territory remaining with the Spanish or French?

Today, Ha! post-air conditioning we've a net migration to the formerly lagging "sun belt" states.

Message? Think longer term than a short term fiscal crisis?

[Jack]

Back taxes: You and the other desperate spammers really ought, out of fairness, contribute more........ or at least something to justify your existence. Thnx!

[lee]

that's really a bad news.

[Peter]

American people has much more money. He must give to European who needs now. To Greek to Italian to Spanish. American people take all the world money and now other people poor. American salary $50,000 must give to other 90% of world only $5,000 salary. World democratic, poor people vote take from rich American give to poor many. American with $50,000 must give half money to poor world. Obama now maybe understand he good democratic make American work for also other of world. One day we all vote and American $50,000 no more. World become more justice.

[D. Fong]

Investors have lost hope that people operating under the flat effort-reward curve of the welfare state (europe) will be able to compete with a rising humanity of three billion in the ascending BRIC countries. Therefore if you lend money to a croup that is loosing competitiveness, you'll likely loose your money, especially since the proposals are to further flatten the European effort-reward curve by expanding intra-national welfare transfers to cross-national welfare transfers across the European union.

It's just as simple as that.

People in Asia have finally awaken, albeit to a still limited form of capitalism and are baffled at European lemmings hanging on to preserve prosperity under the ever flattening effort-reward curve of the welfare state. Can one imagine what will happen once the three billion in Asia take on the full freedom and production of capitalism?
Europe will be history. Well. They already are. They are declining so fast that they don't even have time to digest it.

[Calista Moves]

Yet some more pessimistic news on the Euro crisis. The unfortunate thing is that there were plenty of signs that called for a more adequate reaction way in advance!

[Robert]

I have a question, what is the difference between a revaluation and a default. If I'm a bond-holder and I get less than 100% of principle back, is revaluation of the currency better? Isn't it just a transfer of wealth from the savers to the spenders? Is it because it would hide the cost in the form of more expensive goods and deterioration of savings? Would it truly lead to long term fiscal balances between expenditures and tax revenues?

From what I understand there is sentiment in Greece that Germany should pay for their liesure time in the form of early retirement and lower taxes because Germans are rich. I've even heard that the Germans made out because Greeks bought German goods. I'm not sure how the Germans would be better off if the Greeks did not in fact pay for those goods, i.e. defaulted on the loans to pay for said goods. It seems like the myth that rich countries make poor countries poor so they owe them something.

[TANSTAAFL]

Jack -- with doubts, I'd say we may agree on the principle. But we plainly disagree on the example to illustrate the point. To give it a try, the plain fact is that productive residents of California are unable to devalue their currency to compensate for the abominable fiscal decisions of California lawmakers out to buy votes from nonproductive residents. Consequently, as is well documented by now, productive Californians are voting with their feet and moving to "red" states like Texas.

Now consider the parallel between currency valuation and an electorate voting with their feet. 100 words or less, please, Jack.

[Back Taxes]

Im not a spammer, you are jack. With your Budlight drinking, nascar watching, hardass ideals.

[Eeste]

TAANSTAFL, The point is exactly to create a strong and just central government in Washington that will prevent people from escaping via  what you call “voting with their feet”. This is especially true since these are the people who can produce (..according to their ability) and must thus provide for the many (..according to their need). Once the dream of a just centralized government prevents the competent from escaping then the long sought HOPE can be implemented. That is the hope that productive/competent/hard working  people  will:
 
(a)    Either be CONVINCED to work NOT for their families but for distant unknowns instead
 
(b)   Or be FOOLED not once and twice but time and again in perpetuity via macroeconomic gimmicks which retrospectively confiscate a large portion of past work so that the reward can be used to benefit the general public, rather than the original producer
 
(c)    Or finally, if need be, COERCED into rewardless production.
 
As a matter of fact we in America (who somehow serendipitously became the most prosperous nation in the world through the world despised cowboy mentality of selfishness) seem to be the only nation that is now figuring out how to move forward: We are now finally discovering that the key to prosperity is coercion.
 
If only other nations would see how motivated people become when all citizens work for each other under a centralized plan, to now benefit not their families but distant others as a whole, then all those other nations would also prosper. Like we will under HopNChange. Funny how nobody else seems to have figured that out before. I’m telling you, America is a special place. America can copy others but somehow still succeed in staying most prosperous country in the world. There’s just something inexplicably ethereal about America’s destiny of success. So nothing to worry, just copy Europe.
 

[Ken McKenna]

"[T]he weaker 'Mediterranean' countries ... anticipated much lower interest costs on their sovereign debt because they expected the strong EU nations to provide a guarantee of their debt. These countries also expected that the Maastricht Treaty and other fiscal rules would prevent their governments from running up large deficits. At first, these expectations were met, as interest rates on the sovereign debt of weaker countries fell to levels not much above that of Germany’s..."

That's one explanation, but has this theory been verified? It's odd (to me, at least) that an implied northern guaranty could have such a big effect, since Germany and the rest of "northern" Europe can't support the Mediterraneans unless the Mediterraneans seriously reform both politically and fiscally. There was never a guaranty of Mediterranean reform. What would be Germany's credit rating if it outright guaranteed the debts of Greece, Italy, Spain, Portugal and Ireland without the confirmed and extensive political and fiscal reform of these debtors? Junk?

And how important could the Maastricht Treaty and other fiscal rules really have been in determing those near-German Mediterranean interest rates, since the rules were openly flouted pretty much from the beginning? Greece even lied egregiously about its deficits before joining the Euro, and many knew or seriously suspected that.

A country that issues debt denominated in its own fiat currency can substantively default by either (1) not paying or (2) paying off the debt in debased currency. When the Mediterraneans joined the Euro they gave up the possibility of substantively defaulting by method (2), debasement of the currency of denomination. Would it not make sense that post-Euro bondholders would demand less interest for that removed risk, at least until the breakup of the Euro became a practical prospect? That breakup will impose huge costs on ALL of Europe, northerners and Mediterraneans alike. Would it make sense that bondholders relied more on the disinclination of all of Europe to incur those huge costs than they were on an implied guaranty of northerners to pay debts they couldn't meet in the first place?

Is this an alternative explanation, a wrong explanation or just a rephrasing of the original explanation?

[boyi]

最近英国的威廉王子与准王妃凯特的婚礼将人们的兴趣转向了对皇室婚礼的期待。无论是哪个国家，皇室的婚礼都会成为大家关注的焦点。而准新娘身价不菲的冬装新款也让人惊艳不已。梅特•玛丽特王妃的这款婚纱礼服设计比较简单，由挪威婚纱礼服设计师Ove Harder Finseth进行设计。这款冬装新款采用经典的长袖设计，新娘一个桂冠和一个老式的面纱就搞定。非常具有怀旧意义。