The Question of Eurobonds—Posner

Several countries that belong to the Eurozone and thus use the euro as their currency are in peril of defaulting on their sovereign debt. (In fact Greece is certain to default.) If they default it will probably alleviate their economic woes, because their sovereign debt will (in a total default) be wiped out. They may not even have to pay high interest rates to borrow more money, because with their existing debt wiped out their ability to pay interest on new debt will be greater. Nations have defaulted in the past without terrible consequences; and the deeper the economic hole a nation finds itself in, the less costly default is. 

Still, these countries would prefer not to default. They would prefer to borrow at low interest rates. (Who wouldn’t?) They want the European Central Bank to buy their sovereign debt with bonds issued by the bank, bonds that these countries would pay back at their leisure. Naturally the stronger countries of the EU, especially Germany, do not want to throw good money after bad by lending on generous terms to the PIIGS (as they are no longer called in respectable circles—now they are called GIIPS, an acronym that is not be pronounced with a soft g). Instead they want to secure these debts by persuading or coercing the PIIGS to slash their government spending, so that their revenues, diminished by the worldwide depression though they are, will cover their debt service and thus stave off default. 

The PIIGS don’t want to slash their spending, and for good reason; the standard recipe for combating depression is to increase government spending. If consumers are reluctant to consume, and as a result production and employment fall, and with it borrowing and hence interest rates, government can borrow cheaply from the private sector, and it can use the borrowed money to stimulate production and employment. That was Keynes’s recipe for fighting unemployment, and it is a sensible recipe if the stimulus program is timely, well designed, and well executed. That’s a big if, but it’s unclear what alternative the PIIGS have. In the long run they could increase government revenues by a combination of tax reform, more aggressive tax collection, reduction of bureaucratic impediments to the formation and expansion of businesses, deregulation (especially of labor markets) and privatization, reduction of public employment, and shrinkage of entitlements programs. But such reforms would take years to bear fruit, and might be reversed at any time, and their short-term impact on the economies of these countries would probably be negative. The PIIGS, with the exception of Ireland, have very bad political cultures, and bondholders would be unlikely to trust the governments of these countries to make timely and effective reforms. 

At present the European Central Bank and the wealthy northern European EU members are in a game of chicken with the PIIGS. The former want reform and the latter want handouts. Games of chicken can end badly. This one would not, were it not for the fact that all the countries involved share one currency. Indeed, were it not for the single currency there probably wouldn’t be a game of chicken because, as Becker emphasizes, the single currency is preventing the PIIGS from devaluing, and devaluation is the standard solution to depression for a country that has a large external trade. By devaluing it reduces the prices of its exports, increasing demand, which in turn increases domestic employment because exports are domestically produced. At the same time, devaluation increases the price of the country’s imports, which reduces the demand for imports but increases the demand for domestically produced goods and services, as they are substitutes for imported goods and services. (A complication is that imports include inputs into exports, and so an increase in import prices will offset to an extent the reduction in the price of exports brought about by devaluation.) 

A common currency wouldn’t be a problem if it were easy to change currencies, but it is very difficult, especially when the country wanting to change its currency is economically weak. Devaluation by definition reduces the value of a currency, so anticipating that abandoning the euro would result in its replacement (in Greece, say) by a devalued local currency (the drachma), Greek holders of euros would be quick to exchange them for dollars or yen. The rate of exchange would be disadvantageous to them, however, and so there would be a net money flow out of Greece, making the country’s economic state even more desperate than it is. Moreover, the change in currency would affect not only sovereign debt, but all private contracts in euros as well, which would greatly impede the country’s foreign trade. And setting up a new currency takes time and cannot be concealed, so as soon as the setting up began, the run on euros would begin. 

What a mess! Which is why the wealthy eurozone countries are frightened by the prospect of some or all of the PIIGS dropping out of the eurozone and why therefore the PIIGS have some leverage in demanding handouts in exchange for promises (unlikely, in my opinion, to be fulfilled) of austerity and reform.

Comments

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