Does the debt crisis in Europe spell the end of the single currency?
By Richard Marston | In 1995, Italy had to pay a 12 percent interest rate on its government bonds at a time when Germany could offer 6 percent less. This difference prevailed for a simple reason: bond investors demanded a premium for Italian bonds in case the Italian government once again let the lira depreciate against the deutschemark and other stronger European currencies. The Maastricht Treaty, signed in late 1991, was designed to eliminate such currency depreciations by replacing national currencies with a single currency, the Euro.
By 1998 Italy had satisfied all the conditions necessary to join the new Euro area. This was quite a remarkable achievement because the treaty required, among other things, that the country reduce its budget deficit from almost 10 percent of GDP to 3 percent. Once it was accepted into the currency area, Italy could expect its interest rates to “converge” to German levels.
Indeed that is what happened, and Italy’s experience was shared by the other states joining the new Euro area. Countries such as Spain and Ireland also saw their interest rates converge to a common Euro-area level.
The Euro began trading as an electronic currency at the beginning of 1999, at which point all of the area currencies were tied irrevocably to the Euro. At the beginning of 2002, the old national currencies disappeared. The Euro area included the original six members of the European Economic Community (France, Germany, Belgium, Luxembourg, Italy, and the Netherlands) plus six others (including Greece, which qualified to join the Euro area only in 2002). Now there was one currency area stretching from Ireland to Portugal to Greece.
This was quite an achievement. Gone were currencies like the French franc and Dutch guilder, which had existed for centuries. The costs of changing one national currency to another disappeared overnight. Since so much trade is conducted among members of the Euro area, the resulting gain in economic efficiency was significant. Exporters and importers, moreover, no longer had to worry about currency risks. If a Dutch firm exported goods or services to Italy, it no longer had to worry about a possible depreciation of the lira before the transaction was completed.
With interest rates so much lower than before, the economies of countries that had previously had high interest rates—such as Italy, Spain, Greece, and Ireland—boomed. In Spain and Ireland, there was an enormous housing boom, while in Greece lower interest rates encouraged the government to increase its spending financed by new debt. In many of the so-called “periphery” countries of the Euro area, wages and prices rose. And unlike in earlier times, the increase in costs did not lead to a speculative attack on a country’s currency—since there was no longer a national currency to attack.
Now consider the interest rates that Greece and Ireland have to pay today for their government bonds. At times in the past few months, Greek and Irish bonds have had to pay even more of a premium, relative to German bonds, than Italian bonds did back in 1995. But now the interest rate premiums are not to compensate for expected currency depreciations. After all, neither Ireland nor Greece has its own currency anymore. Instead, higher interest rates are paid on Greek and Irish debt because bondholders fear a possible default on the debt. Like companies in the United States of lower debt quality, the bonds of Greece and Ireland are now rated as “junk,” with interest rate premiums reflecting their new status.
The path to junk status was different in Ireland than in Greece. As late as 2007, Ireland’s government deficit was less than 1 percent of GDP, because the Irish government never allowed its spending to rise much faster than its tax revenues. Greece, on the other hand, had no such restraint. Worse still, the Greek government in power until October 2009 actually misled investors by hiding its true government deficit. When the new Socialist government led by Prime Minister George Papandreou assumed power in the fall of 2009, it revealed that the deficit would reach 12.7 percent of GDP that year. With deficits that high, the bond market began worrying about possible default. So the spreads of Greek interest rates above German interest rates widened sharply.
If Ireland kept its government deficit under control, how did it descend to junk status? The answer is that the Irish government decided to rescue its banks. Recall that the Irish economy experienced a housing boom. As in many real estate booms, banks became heavily indebted and vulnerable to a loss of confidence. When the financial crisis began in 2008, the Irish government extended guarantees to all bank depositors. And it threw a protective umbrella around other bank liabilities. So the Irish government absorbed the losses of the Irish banks. A government with sound fiscal management was transformed into one with substantial default risk.
It’s important to realize that evaluation of default risks does not have to be subjective. There are markets out there telling us what investors think of Greece and Ireland (and Illinois and California, for that matter). The bond market provides prices for government debt continuously. If investors demand interest rates 6 or 8 percent higher on Greek bonds than German bonds, that tells us that they believe there is some probability that Greece will actually default on these bonds.
Is the situation hopeless for Greece and Ireland? There is a way for Greek and Irish debt to be restored to investment-grade status overnight. All we need is for the stronger nations of the Euro area to guarantee the debt (and provide a steady stream of tax revenues to be transferred). In a full fiscal union, German (and Dutch and other) taxpayers would bear the burden of overspending in the periphery countries. Some experts in Europe have called for such a fiscal union.
To see why this might not be a welcome solution to all, consider the emerging state- and municipal-government fiscal crises in the United States. Suppose that one state (let’s call it Transylvania, so as not to offend any reader) has been so profligate that a default on its bonds is imminent. It’s possible that the US government might bail out Transylvania without any strings attached. That is, the US government will raise taxes on citizens of every state (or, more realistically, issue Treasury bonds to be paid off later by US citizens of every state) to bail out the citizens of Transylvania. Many citizens of the United States would consider a bailout of Transylvania to be unfair. But that is what a fiscal union does.
In practice, it is likely that the federal government will play some role in rescuing Transylvania even if it stops short of writing a blank check to that state. In the case of the European Union, that rescue took the form of a €750 billion ($1 trillion) bailout fund established by the EU in early May 2010. The rescue fund was meant to provide temporary financing while the countries under attack put their fiscal affairs in order. How do we assess the success of this fund? The market does that for us. As of January 2011, Greece was paying an interest rate on its bonds almost 8 percent above that paid on German debt, and Ireland was paying a 6 percent premium on its bonds. Evidently the markets don’t believe that this rescue package is going to solve the problem. The markets still believe that there is a significant chance that the bonds will eventually default. The markets might be wrong. But I wouldn’t bet against them.
It’s possible to imagine that Greece and other countries could be forced into a debt restructuring. The specific form this might take can only be guessed at this time. One idea floated recently is for the Greeks to buy back their own bonds—at their current discounted prices—using financing provided by the European Union. It’s a little harder to imagine that a country like Greece would drop out (or be forced to drop out) of the currency area itself. Imagine the difficulty. The government would have to ask its citizens to turn in their Euros for newly minted “drachmas.” And it would have to ask bondholders to trust the new currency. Can you imagine how high the interest rate would have to be on bonds denominated in new “drachmas”?
Will Greece and Ireland’s problems take down the Euro itself? The situation remained very fluid in the first month of 2011, but I think that is quite unlikely. Political and economic pressures may force the Greeks and Irish to partially default on their debt, inflicting losses on investors in their bonds. Because Greek and Irish bonds are owned substantially by French, German, British and other European banks, there will be pressure on Europe’s stronger governments to prevent a total default. The trick will be finding the proper balance—imposing enough pain on their domestic bondholders, but not too much.
So the Euro will survive this crisis. A common currency has too many advantages for a regional economy as integrated as is Europe. Older Penn graduates can remember a time when you had to show passports to travel from one country to another in Europe. Train conductors would even wake travelers up in the middle of the night to make sure that all documents were in order. Now integration has proceeded so far that international trade is nearly seamless, financial flows unencumbered, and a single currency is used throughout much of Europe. Fiscal problems in Greece and Ireland are not going to reverse these gains.
Richard Marston is the James R.F. Guy Professor of Finance at Wharton, and the director of the Weiss Center for International Financial Research.
