Managing the eurozone’s fragility
By Martin Wolf
Published: May 3 2011 19:03 .
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Why is Spain paying higher interest rates on its government debt than the UK? The answer to this question is illuminating: membership of a currency union makes a country fiscally fragile.
This is inherent in the construction: members are neither sovereign states nor components of a federation. The big challenge for the eurozone is to resolve this contradiction.
In an important paper, Paul de Grauwe of Leuven university notes this contrast between the current positions of Spain and the UK. The yield on Spanish government 10-year bonds is almost two percentage points higher than that on UK equivalents, at 5.3 per cent against 3.5 per cent. This is a bigger difference than it may seem. If one assumes that the Bank of England and the European Central Bank both meet their 2 per cent inflation target, Spain’s real interest rate is more than double that of the UK.
Do the fiscal positions of the two countries explain the contrast? Not obviously: Spain will have lower ratios of net and gross public debt to gross domestic product until at least 2016.
It will also have lower fiscal deficits until 2014 and a lower primary fiscal deficit (before interest payments) until 2013. (See charts below.) True, according to the International Monetary Fund, the UK fiscal deficit is forecast to be 1.3 per cent of GDP in 2016, against Spain’s 4.6 per cent. And differences in primary deficits explain 2.9 percentage points of this gap. But even this is not solely due to a difference in fiscal effort, since Spain’s economy is forecast to grow on average by 1.6 per cent between 2011 and 2016, while UK average growth is forecast at 2.4 per cent.
As Prof de Grauwe notes, the liquidity of debt markets is vital. If, say, a government rolls over its debt every six years and also runs a fiscal deficit of about 3 per cent of GDP, it needs to issue new debt equal to a fifth of GDP every year. Suppose new buyers disappeared: we would see a “sudden stop” and a default. Suppose creditors think such illiquidity is indeed a risk. They would refuse to buy the bonds, rates of interest would soar and the economy would collapse. But it makes no sense to buy bonds at high interest rates either: the higher the interest rate, the more likely is a forced default.
If there were doubts about the UK government’s liquidity, creditors would sell bonds in return for sterling deposits. They might then sell those sterling deposits for foreign currency.
The pound would depreciate. But new holders of sterling deposits would need to buy sterling assets, probably including bonds. If the worst came to the worst, the Bank of England could tide the government over until fiscal stringency worked. The depreciation of sterling would also stimulate net exports, raising confidence in fiscal prospects. Thus, the UK cannot face a liquidity crisis in its sterling debt and any doubts about solvency are likely to lead to helpful adjustments.
For Spain, however, doubts about liquidity can readily arise. These risk creating self-fulfilling expectations, as rates of interest rise and money leaves the country. The result would be illiquidity in both the market for public debt and the banking system. The country has, in effect, become like a developing country that has borrowed in foreign currency, except to the extent that the ECB finances the banking system. Yet that makes the latter very like the IMF: it is determined to get its money back.
Hamlet says that nothing is either good or bad but thinking makes it so. In the case of public debt, that is an exaggeration: a country with debt of, say, four times GDP surely will have a fiscal crisis and one with debt of zero will not. (Even this is too simple, once one allows for banking: Ireland’s net debt was a mere 12 per cent of GDP in 2007.) Yet between such extremes lie many possible outcomes – “multiple equilibria” in the jargon. What people think creates reality: at current interest rates, the UK can run a primary fiscal deficit while stabilising its debt ratio but Spain needs a sizeable primary surplus if it is to do so.
Moreover, after a crisis, the victim must regain competitiveness. This is a slow process within a currency union. It also worsens the debt overhang, in real terms: thus adjustment is itself destabilising.
The eurozone is inherently fragile. Moreover, because of the financial connections inside the union, the fragility of one is the fragility of all. What can the eurozone do about this? I see three alternatives: accept fragility; become more homogeneous; or move towards a far closer union.
The first option is to make the eurozone work like the old gold standard. In such a world, governments would not stand behind financial systems and fiscal policy would be brutally pro-cyclical and without monetary policy offsets. It would be a “great leap backward” into the 19th century. I find it hard to imagine that today’s Europeans would accept such an outcome.
The second option would be to limit the eurozone to countries so similar to one another that large divergences are unlikely. But moving in that direction would involve the transitional shock of partial break-up. Moreover, structural surplus countries would suffer from what is likely to be a huge appreciation.
The third option is to move toward far closer union. That is what the eurozone is slowly doing. But, as Prof de Grauwe notes, it is doing so in a halfhearted and muddled manner: the emergency assistance is too small; the interest rates on offer have been destabilisingly high; and the proposed “collective action clauses” on bonds issued after 2013 guarantee future crises. Prof de Grauwe recommends, among other things, the collective issuance of euro bonds, up to 60 per cent of the GDP of each member, and collective supervision of financial excesses.
Yet even all this does not go far enough. Consider what the federal government is able to do in a US crisis. If, say, California defaulted, its federally insured financial system would survive and social security and health benefits would continue to be paid. Default by a state would be painful but not catastrophic. Defaults by European governments are sure to create far bigger crises. By joining the eurozone, members have lost domestic insurance mechanisms but they possess very limited eurozone-wide replacements.
The eurozone must move forward, or go backwards. I assume it will choose the first option. But that is a political choice. Either people and politicians believe they share a common destiny, or they do not. This choice may not be made tomorrow. But it has to be made.
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Copyright The Financial Times Limited 2011.
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