WHY IS THE EUROZONE DIFFERENT ? PART 2 / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Why is the eurozone different? Part 2
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Martin Wolf
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May 19, 2012 12:58 am

I have noted in the first part of this blog that the debts of countries in the eurozone have suffered a very different fate from those outside the eurozone during the crisis. This is evident when one compares the yields on sovereign bonds of the UK with those of France, Italy and Spain, countries that on the face of it, have governments at least as solvent, if not more so.



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So why has the experience of the eurozone members been so different and so painful and what can be done to remedy the problem?



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There are two possible explanations, which are not mutually exclusive.


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The first explanation is that a country with its own currency enjoys access to the captive savings of its private sector. The reason why people keep most of their financial assets in the domestic currency is that this is also the currency of most of their spending and of course, of the taxes they pay. Currency mismatches are also very dangerous in a world in which the currency might shift a large amount in a short time.



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After a crisis, the private sector will also often (though not always) have a large financial surplus – that is, an excess of income over spending. This must be spent either on the liabilities of the government or on foreign assets. The former purchases fund the government directly. The latter drive down the external value of the currency, which will result in improved prospects for the economy and strengthening the public finances.




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The position of eurozone members is very different. A Spanish resident may buy German bunds, instead of Spanish bonds, with no currency risk or to the extent such risk exists, it is only on the upside. The same is true for any other euro-based person. Thus, the debt of the government of Germany – both the largest country and one with a strong creditor position – has emerged as the safest asset in the system. Its price has risen as its yields tumbled. It should be grateful, but does not seem to be. Meanwhile, the debt of sovereigns deemed less secure than that of Germany risks being turned into junk.



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Suppose that the interest rates on the bonds of the weaker sovereigns soar. Suppose, too, that there is limited official support for those bonds from the central bank (that is, the European Central Bank) or other governments. Then the government of the weaker sovereign will be forced into fiscal austerity. Quickly, the nominal rate of interest will become far higher than the prospective growth of nominal gross domestic product.


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The government will find itself in a debt trap. It will need a large primary surplus (before interest payments) to constrain the growth of its stock of debt relative to GDP. But the weakness of the economy will limit its ability to achieve such a surplus. Awareness among investors of the trap will automatically make it deeper. This is why deflating a government back into solvency is so hard once interest rates become high.



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The point is made below. The picture is particularly striking for Spain. Between 1995 and 2007, Spain’s nominal GDP grew on average 7.4 per cent a year. Between 2010 and 2014, this average is forecast by the International Monetary Fund to be just 1.2 per cent a year. For Italy, the corresponding average growth of nominal GDP was 4.5 per cent between 1995 and 2007, but again, the forecast average rate is 1.2 per cent a year between 2010 and 2014. Nominal interest rates on government bonds of 5-6 per cent will not work with such depressed growth of nominal GDP.

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The second explanation for the high bond yields of governments in the eurozone is that a member of a currency union does not have a central bank of its own. This then creates liquidity and default risk in the market for government bonds.


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Investors in government bonds should know that they have no collateral. So expectations of repayment depend on the ability of the government to refinance debt, since the latter can never pay it off: the market for government debt is lifted by its own bootstraps. Without a central bank, a time may arrive when the government is unable to refinance its debt. That creates tail risk – the likelihood of being trapped in debts whose maturity will be forcibly extended or on which the government will default.



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These risks will come to investors’ minds during a crisis. Liquidity will then dry up and investors flee. Only the central bank can halt such a “run” or market panic. But, by assumption, the latter will refuse to take the needed action.



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Paul de Grauwe, who now teaches at the London School of Economics has put the point forcefully.

In a nutshell the difference in the nature of sovereign debt between members and non-members of a monetary union boils down to the following. Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are no part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.

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Another way of looking at the absence of a central bank is as follows. The yield on a bond with no default risk should be the weighted average of expected short rates of interest. Thus for an economy in deep recession, with no serious risk of inflation over the relevant horizon, expected short-term interest rates will be low and so, as a result, will be the yields on bonds. This then explains the UK’s very low bond yields, since it has (next to) no default risk.



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Yet bonds of eurozone member states do have default risk, since in effect, they borrow in a foreign currency, as have many emerging economies in the past. Investors now know of this risk not just from theory, but from what has happened in Greece. The expectation of ultra-low official short-term rates will not, in these cases, determine the yield on bonds, because the possibility of default will also enter the calculation. Worse, the probability of default is a function of the interest rate on the bonds: the higher is the rate, the greater is the probability of default. So yet again, governments may enter a trap in which the higher the interest rates they have to pay the smaller is their perceived likelihood of avoiding default.


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What then could be done to reduce this dangerous fragility inside the eurozone? That will be the subject of my next post.